Since tax filing time is coming up, I thought I would share an interesting story concerning the taxation of personal injury settlements. The tax code includes a provision exempting such settlements from income taxes, so if you receive such a settlement as a result of a motor vehicle accident, slip and fall, medical malpractice, or any other wrongfully-caused personal injury, you do not need to report it.
It is also common for defendants and insurance companies, particularly in high-profile cases, to require the injured person to sign an agreement to keep the terms of the settlement secret. Dennis Rodman was famous for his ferocious defense and rebounding skills during his long career in the NBA. His tattoos, piercings, and wild off-the- court partying lifestyle also made headlines. But you may not know that he was involved in a landmark tax law case that created new law allowing the IRS to tax personal injury settlements, which include secrecy agreements.
On January 15, 1997, Rodman was in his prime with the World Champion Chicago Bulls, and the Bulls were playing the Minnesota Timberwolves. After scrambling for a loose ball, Rodman fell into a group of courtside photographers. As television cameras rolled, while getting up, Rodman kicked cameraman Eugene Amos in the groin.
Amos later sought treatment for groin and back injuries, filed a police report, and retained a lawyer to pursue personal injury claims against Rodman. Before a formal lawsuit was filed, the attorneys for Amos and Rodman negotiated a $200,000 settlement, which included a secrecy agreement. Amos did not claim the $200,000 on his 1997 Tax Return.
To his surprise, the IRS claimed that he should have reported the money as income, because his injuries were minimal and the monies were really paid for the secrecy agreement.
At the end of the case, the court determined that the $200,000 settlement had to be allocated between the amount paid for the personal injuries (which was exempt from taxation) and the amount paid for the secrecy agreement (which was taxable). Ultimately, the court arbitrarily allocated $120,000 to the personal injuries and $80,000 to the secrecy agreement.
Because, based on the Amos case, secrecy agreements lead to tax consequences in personal injury cases, the following are some practical tips to avoid potential problems:
Don’t agree to confidentiality. A secrecy agreement leads to tax problems. If a defendant insists on confidentiality, get more money in the settlement. If a defendant requires privacy, it should come with a price.
Allocate and specify. If money is being paid for injuries and confidentiality, make sure that a written settlement agreement allocates the money between the two.
In addition, be specific about the physical injuries, which are being compensated for in the settlement. If the specific injuries being compensated for are listed in the settlement agreement, that helps bolster the argument that a majority of the money was paid for those injuries, rather than for secrecy.
As a practical matter, it has been my experience that most settlement agreements allocate only a nominal amount, such as a dollar, to the secrecy agreement. Particularly in cases involving sex harassment and discrimination, such as the Harvey Weinstein cases, secrecy agreements are coming under fire, because they allow “bad actors” to continue their misconduct without fear of discovery.
However, there are good reasons for using them, especially since plaintiffs as well as defendants often want to avoid publicity about their settlements. If you are involved in such a case, make sure to discuss these issues with your lawyer.