Are “Nondisclosure Agreements” Taxable?
Author: Attorney John R. Orton
“Nondisclosure agreements” (NDA) or “confidentiality agreements” are becoming more popular in litigation settlements. In some cases, the parties wish to add a “nondisclosure” clause to their settlement agreement to keep the terms and conditions of the settlement confidential and out of the public eye. These agreements usually prohibit the parties from releasing any information regarding the settlement and impose a penalty if a party violates the agreement.
A tax problem has arisen with the IRS, which takes the position that payments received for a nondisclosure agreement are taxable. In Amos v. Commissioner of Internal Revenue, T.C. Memo. 2003-329 (Dec. 1, 2003), the IRS evaluated the settlement of a claim between a photographer and Chicago Bulls basketball player, Dennis Rodman. During a game, Rodman chased a ball out of bounds and was tripped up by a photographer. In a fit of anger, Rodman kicked the photographer as he re-entered the court. The photographer sued, and a settlement of $200,000.00 was reached. The settlement included a “confidentiality clause.”
Personal injury settlements are usually tax free. However, in this case, the IRS claimed that part of the $200,000.00 was not compensation for personal injuries, but compensation to keep the settlement quiet. The tax court agreed and concluded that $80,000.00 of the settlement was for the non-disclosure clause and, therefore, taxable.
To avoid this problem, there are several things you should consider:
- Avoid using nondisclosure agreements altogether;
- If you use a nondisclosure clause in a settlement agreement, specifically allocate an amount toward the physical injuries and an amount toward the nondisclosure clause;
- In the agreement, make the nondisclosure provisions “mutual” so that the consideration flowing between the parties is equal and not part of the settlement paid for physical injuries.