United States Court of Appeals FOR THE EIGHTH CIRCUIT

___________ No. 96-1768

___________ Hughes A. Bagley and * Marilyn B. Bagley, *
* Appellants, *
* On Appeal from the
v. * United States Tax Court.
*
* Commissioner of Internal Revenue, *
* Appellee. *

___________ Submitted: June 9, 1997 Filed: August 6, 1997

___________ Befo re RICHARD S. ARNOLD, Chief Judge, HENLEY, Senior Circuit Judge, an d WOLLMAN, Circuit Judge.

___________ RICHARD S. ARNOLD, Chief Judge.

InAugust 1987, Hughes Bagley settled an eight-year-old lawsuit against Iowa Beef Proce ssors, Inc. ("IBP"), for $1.5 million. In their tax return for that year, Mr

. Bagley and his wife, Marilyn Bagley, exc luded the entire settlement amount from their taxable income. The Commissioner determined that $1,305,000 of the $1.5 m illion was not excludable and asserted a deficiency in the Bagleys' 1987 income tax, aThe Honorable Irene F. Scott, Judge, United States Tax Court. 1
-2- determination which the Bagleys contested in t he Tax Court. The Tax Court held that 1 $500,000 of the settlement was not excludable, Bagley v. Commissioner , 105 T.C. 396 (1995), and the Bagleys appealed. We affirm.

I.

This case addresses the tax consequences of a settlement that followed ou r decision in In re IBP Confidential Business Documents Litigatio n ( Bagley v. Iowa Beef Processors, Inc. ), 797 F.2d 632 (8th Cir. 1986) (en banc), reh'g denied , 800 F.2d 787 (1 986) (en banc), cert. denied , 479 U.S. 1088 (1987). The facts of the case ar e recounted in that o pinion, and there is no need to detail them here. What is important forp urposes of this appeal is that a jury in 1982 found IBP liable to Bagley on fou r separate claims and awarded compensatory damage s in the amount of $1.5 million and punitive damages in the amount of $7.25 million. The breakdown was as follows:

Claim Compensatory Punitive Tortious interference with $ 150,000 $ 500,000 present employment Tortious interference with $ 100,000 $ 250,000 future employment Libel $1,000,000 $5,000,000 Invasion of Privacy $ 250,000 $1,500,000 Total $1,500,000 $7,250,000
In response to IBP's subsequent motion for judgment notwit hstanding the verdict, the District Court dismissed the invasi on-of-privacy claim, finding that the jury's award

was duplicative of the libel award, but upheld the remaining three claims. On appeal, this Court reversed the libel judgment and remanded the libel claim for a new trial-3-

b e cause the District Court had erroneously instructed the jury that defendant IBP bore the burden of proof on a key issue. This Court affirmed the judgment on the tortiousinterfe rence-with-present-employment claim. In addition, we upheld the tortious

interfe rence-with-future-employment judgment with respect to liability but vacated i t with re spect to damages. We then remanded with instructions that if Bagley prevailed on his libel claim on retrial, the District Co urt should then determine the extent to which the tortious-interfere nce-with-future-employment damages were duplicative of the libel award

. After our decision, in denying as premature Bagley's motion to reinstate th e invasion-of-privacy award , the District Court stated that if Bagley lost his libel claim at trial or elected not to pursue it further, the Court would be inclined to reinstate th e awards for invasion of privacy and tortious interference with future employment.

Less than two months before a new trial on the libel claim was scheduled to begin, the pa rties met for a settlement conference. During the conference, IBP's lawyer tol d Bagley's lawyer that IBP would not agre e to pay punitive damages. After two weeks of negotiati ons, the parties agreed to settle the case for $1.5 million. The settlemen t agreement stated that the award was paid "as damages for personal injuries includin g alleg ed damages for invasion of privacy, injury to personal reputation includin g defa mation, emotional distress and pain and suffering." IBP also agreed to dismiss a pendin g cause of action that it had filed ten years earlier against Bagley, and Bagle y agreed to return to IBP business documents that he had in his possession. Th e parties also agreed to use their best efforts to keep the terms of the settlemen t confidential. Bagley released all his claims against IBP, including, necessa rily, any claim for punitive damages.
On their 1987 tax return, the Bagleys excluded the entire amount of the se ttlement fr om their taxable income. The Commissioner maintained that $1,305,000 of th e settlem ent

agreement was a taxable award of punitive damages and asserted a defici ency in the Bagleys' 1987 income tax. The Bagleys filed a petition in the Ta x Court challenging the Commissioner's determination. They first argued that punitiveThe Tax Code now expressly states that punitive damages are not excludable 2 from income. See 26 U.S.C. § 104(a)(2). The Commissioner does not contest the Tax Court's decision on appeal. 3
-4- damages are not taxable, a position with which the Tax Court disagreed, and one that is no longe r tenable given the Supreme Court's recent decision in O'Gilvie v. Unite d States , 1 17 S. Ct. 452 (1996). In O'Gilvie , the Court held that the Internal Revenu e Code's exclusion for damages "received on account of pers onal injuries" did not include punitive damages and, therefore, that punitive-damage awards are taxable income. The 2 Bagleys have abandoned their challenge to this part of the Tax Court's holding o n appeal.
Second, the Bagleys arg ued that none of the $1.5 million settlement represented the pa yment of punitive damages. Accordingly, they argued, the entire amount wa s p roperly excluded as compensatory damages received on account of personal injuries under 26U.S.C. §104(a)(2). While the Tax Court disagreed with the Commissioner's

con tention that $1,305,000 of the settlement was taxable, it also disagreed with th e 3 Bagleys' contention that none of it was. Instead, the Tax Court reasoned that "it i s reasonable to assume that IBP would have paid in settlement to [Bagley] the entire $1 mil lionthat the jury had found he was due as compensatory damages [on the libe l claim ]. However, . . . the remaining $500,000 was in settlement of possible punitiv e damages [Bagley] might have recovered." 105 T.C. at 410. The Court thus held that "of the $1.5 milli on settlement amount, $1 million was for compensatory damages and $500,000 was for punitive damages." Ibid. This appeal followed.Bagley's failure to appeal the original dismissal of the invasion -of-privacy award 4 allowed the dismissal to become final and thus created s ome uncertainty about whether the District Court could have reinstated the invasion-of-privacy award if Bagley lost the libel suit. The Bagleys plausibly argued, and the District Court seemed inclined t o agree, that the Dis trict Court could reinstate the judgment under Federal Rule of Civil Procedure 60(b)(5), authorizing relief from a final judgment where the judgment was based upon "a prior judgment" that has since "been reversed or otherwise vacated. " Because the invasion-of-privacy award had been dismissed only because the District Court found it to be duplicative of the libel award, and because the libel judgment that was the basis for the dismissal of the invasion-of-privacy judgment had been reversed by thi s Court, Bagley had a plausible argument that the District Court could use Rule 60(b)(5) to reinstate the invasion-of-privacy award if he ultimately failed to prevail on his libel claim. Thus, while the reinstatement of the invasion-of-privacy award was not a sure thing, it was a likely enough prospect to be worth something in settlement. As the Commissioner points out, this Court's reversal of the libel claim ha d 5 nothing to do with the amount of the claim. Thus, there was no legal bar to Bagley's
reco vering the same amount if he prevailed on retrial. The Bagleys argue that th e second trial might have been different bec ause evidence admitted solely to prove other claims at the first trial would not have been available to Bagley at the retrial of the libel claim. The Bagleys present no evidence, however, that the expected absence of this
-5- II.

When asse ssing the tax implications of a settlement agreement, courts shoul d neither engage in speculation nor blind themselves to a settlement's realities. Se e Delaney v . Commissioner , 99 F.3d 20, 23-24 (1st Cir. 1996) (court must look beyond langu age of settlement to determine "'in lieu of what'" were damages paid) (citatio n omitted) (emphasis omitted). The reality when settlement negotiations began was that even i f IBP had won Bagley's pending libel suit, it almost certainly would have had to pay $250,000 in punitive damages and would also have faced a significant risk o f having t o pay an additional $1,500,000 in punitive damages. If IBP had lost the libel 4 suit, its liability was uncertain, but a jury had already awarded Bagley $5,000,000 i n punitive damages on the claim. Therefore, IBP wo uld in all likelihood have had to pay 5evidence at the second trial materially affected the l awyers' estimation of the likelihood

that Bagley would have received a significant amount of punitive damages if he won his libel claim on retrial.
In McKay v. Commissioner , 102 T.C. 465 (1994), vacated on other grounds , 6 84 F.3d 433 (5th Cir. 1996) (unpublished), for example, the settlement agreement was far more explicit that the defendant did not intend to pay punitive damages i n settlement, and the Tax Court upheld the allocation:

McKa y has necessarily acceded to Ashland's demand tha t nothing be allocated to the RICO claim, punitive damage s -6- a sizabl e punitive-damage award whether it won or lost the libel suit. The Bagleys ' argument that none of the settlement is taxable requires us to believe that this potential liability did not affect the size of the settlement at all, and thus, that IBP paid nothing to Bagley to secure a release from this sizable exposure.

In sup port of this unlikely contention, the Bagleys point to the absence of an y reference to punitive damages in the settlement agreement and the statement of IBP' s lawyer at the commencement of settlement negotiations that IB P refused to pay punitive damages. Both pieces of evidence demonstrate at best that IBP did not want to show

an allocati on to punitive damages in the settlement agreement. But proof of a defendant's desire or intent not to show an award of punitive damage s does not establish that the defendant did not pay something to avoid punitive damages, wh ere there is solid evide nce that the prospect of punitive-damages liability necessarily increased th e amount that the defendant paid in settlement.

The Bagleys argue correctly that the language of a negotiated settlemen t agreement that allocates nothing to pu nitive damages should not lightly be disregarded. Ini tially, however, we note that while the agreement in this case does not expressl y al locate anything to punitive damages, it also does not explicitly say that punitiv e damages are not part of the settlement. More impo rtantly, the language of a settlement 6clai ms, or alleged intentional misconduct claims an d As hland and McKay have both relied upon their appellat e counsel's consensus estimate of McKay's probability o f appellate suc cess with respect to the [claims that defendant Ashland agreed to pay.]
Id. at 484 (quoting settlement agreement).
Indeed, IBP's attorney, an experienced Iowa litigato r, told the Tax Court that he 7 could recall no settlement with which he had been involved that specifically allocated a certain amount to punitive da mages in the settlement agreement. Appellants' Br. 44.

-7- agreement ca nnot always be dispositive. It will almost never be to a defendant' s advantage to allocate part of a lump-sum settlement to punitive damages, and it wil l often be disadvantageous. Often, insurance policies will not cover such awards, an d punitive -damage awards result in worse publicity than compensatory awards. Mos t plaintiffs will not want specific allocations to punitive damages in their settlemen t agreements, because punitive damages are taxable. Therefore, when the time comes to settle a ca se, no matter how adversarial the proceedings have been to that point, th e parties will almost always be in agreement that no part of a sett lement agreement should be explicitly allocated to punitive damages. 7

The Bagley s also rely on the statement of IBP's lawyer during the settlemen t negotiations that if Bagley wanted puniti ve damages, he would have to go to trial. One is tempted to dismiss such a statement as a negotiation tactic. IBP's general counse l stated th at IBP's goal in settlement negotiations was simply to settle for the lowes t amount possible, and the Bagleys do not point to any other evidence suggesting tha t IBP's desire to avoid an allocation to pun itive damages was especially strong. The Tax Court f ound that "counsel for IBP did not want to show an allocation to punitiv e damages" and that

"it was clearly in the interest of both parties not to show an amount allocated to punitive damages." 105 T.C. at 409. Even so, IBP was not in a position-8-

to demand that punitive damages n ot figure into the amount of the settlement, since the prospect of punitive-damages liability was so likely no matter what the result of th e pending libel trial. Proof of IBP's desire to avoid an express allocation to punitiv e damages cannot overcome the evidence that IBP necessarily paid more to sett le Bagley's cl aims against it because of the very real threat of punitive-damages liability that i t faced.

A f

inal piece of evidence that part of the settlement reflects the payment o f punitive damages is that IBP paid $500,000 mo re to settle Bagley's claims than the jury had awarded in compensatory damages on the libel claim, the largest of the thre e awards. While it is theoretically possible that the jury might have awarded even more in compensatory damages on ret rial of the libel claim and nothing in punitive damages, it is far more likely that IBP paid the extra $500,000 to settle the punitive-damage s liability it faced.
Finally , the differences between this case and McKay , supra , 102 T.C. 465 , whic h the Bagleys cite in support of their claim, are instructive. In McKay , a jur y awarde d the taxpayer close to $14.5 million in compensatory damages, $1,250,000 in punitive damages, and $43 million for t he defendant's violation of RICO. In settlement negotiations after the v erdict, the defendant was adamant that no part of the settlement be alloc ated to punitive damages or the RICO claim, and the settlement agreemen t exp ressly reflected that sentiment. The agreement allocated $14,294,300 t o compensatory damages and nothing to punitive damages, and the Tax Court upheld this allocation. Id. at 487.
Several facets of this case distinguish it from M cKay . First, the Tax Court found in McKay that the taxpayer "desired that a portion of the settlement proceeds b e allocatedto the RICO claim in order to publicize [the defendant's] unlawful activity." 102 T.C. at 473. Thus, unlike in the present case where neither side wanted a specific allocation to punitive da

mages in the settlement agreement, the parties in McKay were-9-

genuinely adverse as to the issue of howto allocate the settlement proceeds, and so the Co urt could properly assume that the agreement reflected the reality of the situation

. Second, the agreement in McKayexpressly stated both th at none of the settlement went to pu nitive damages and that the parties came to that conclusion based upon thei r attorneys' estimates of the probability of appellate success o n the punitive claims. Third and finally, unlike in this case, the amount of settlement in McKay (less the amoun t allocated to attorneys' fees) was less than the jury had awarded in compensator y damag es, thus making it plausible that the defendant had agreed to pay onl y compensatory damages.

III.
The Bagleys argue only that none of the settlement in this case was taxabl e. They do not suggest an alternative amount th at the Tax Court should have awarded between

no thing and $500,000. We cannot say that $500,000 was not the proper amount. I t gave the taxpayer the benefit of the largest amount that the jury had awarded i n compensatory damages, and thus the largest amount that could plausibly be allocated to comp ensatory damages. See Robinson v. Commissioner , 70 F.3d 34, 38 (5th Cir

. 1995) (Tax Court did not err in basing settlement allocation upon jury verdict, "the best indic ator of the worth of the [taxpayers'] claims."), cert. denied , 117 S. Ct. 83 (1997). The judgment of the Tax Court is

Affirmed.

A true copy.

Attest:

CLERK, U.S. COURT OF APPEALS, EIGHTH CIRCUIT.