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What Are the Tax Implications of Confidentiality Clauses and Settlement Agreements?

As the tax season has passed and the basketball season winds down, here's a story about how they crossed over years ago and still affect lawyers today.

It was 1997, and the NBA's most flamboyant player had just tumbled into a crowd of courtside photographers during a game. Dennis Rodman, whose career was marked by wild hair and wilder behavior, got up and kicked a photographer in the groin.

The assault turned into a confidential settlement, which later became public when the IRS got involved. The taxman wanted to know how much Rodman paid the photographer.

Ronald L. Burdge, writing for the ABA, said the case illustrates the tax problems with confidentiality and settlement agreements.

No Consideration for Confidentiality

"Of course, the best way to avoid tax issues is to avoid the confidentiality clause," he said. "If that is not possible, then the clause should specifically state the amount of consideration for it or that there explicitly is no consideration being paid for it."

Burdge said tax consequences can be significant if a confidentiality agreement is not carefully drafted. All consideration for confidentiality is taxable income to the recipient, he said.

In Amos v. Commissioner, the Rodman case, the settlement agreement contained a confidentiality clause and liquidated damages for violating it. The tax court had to decide how much of the personal injury settlement was attributable to the confidentiality clause.

"Because the nature of the confidentiality clause itself was compensation for non-personal injuries, then some amount would be taxable," Burdge said. "The settlement agreement was silent on how much, so the analysis fell to the intent of the party making the payment."

On the Rebound

Rodman, who was suspended and fined $25,000 by the NBA, had paid $200,000 to the photographer. The court said $80,000 was attributable to the confidentiality clause.

"Lacking any 'sufficient and clearly stated consideration' in the agreement, the Tax Court was free to assign any 'just or fair amount,'" Burdge said.

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