Opinion ID: 198101
Heading Depth: 2
Heading Rank: 1

Heading: Allocating Prejudgment Interest.

Text: 15 The petitioners' flagship claim posits that, inasmuch as the trial court judgments in the malpractice actions were annulled by stipulation and never became enforceable, the funds that they received can only be classified as lump-sum personal injury settlements (and, therefore, wholly excludable from federal income taxation under section 104(a)(2)). 2 Put another way, the petitioners contend that, in the absence of an enforceable judgment (i.e., one as to which all avenues of direct review have been exhausted, either by unsuccessful appeals or the running of the applicable appeal period) that includes interest, the Commissioner unreasonably chose to go behind the settlement agreements and improvise an artificial allocation. 16 The case law, though sparse, seems to draw a well-conceived line that refutes the petitioners' challenge. When the interest component of a personal injury settlement is difficult to delineate, there is every reason for courts (and the Commissioner) to defer to section 104(a)(2) and treat the entirety as free from tax. After all, a settlement of a claim for personal injuries almost inevitably will take into account a multitude of factors (e.g., the nature of the injuries, the measure of damages, attendant pain, the economic loss, the prognosis for the future, the strength or weakness of the victim's case on liability, the immediacy of the victim's need for funds, the depth of the tortfeasor's pocket, the presence or absence of legal representation, the costs of trial, the extent of anticipated delays, and the availability vel non of punitive damages and/or prejudgment interest), and the parties typically will not assign independent monetary values to each of these factors. To complicate matters further, some of these factors (e.g., the costs of trial) would not themselves bear prejudgment interest. Thus, the absence of an allocation renders it too speculative for a court, in hindsight, to assign independent weight to each relevant factor and isolate a reliable figure representing prejudgment interest. 17 On the other hand, when the interest component of a personal injury settlement can be delineated with accuracy and ease--as when there has been a jury verdict and an ensuing judgment that contains separate itemizations of damages and interest--a subsequent settlement that does not purport to make a different allocation is quite logically viewed as including a pro rata share of interest. 3 See Robinson v. Commissioner, 70 F.3d 34, 38 (5th Cir.1995), cert. denied, --- U.S. ----, 117 S.Ct. 83, 136 L.Ed.2d 40 (1996); Delaney, 99 F.3d at 24 n. 3. In this hermeneutic, the parties have settled a claim for a liquidated amount--and it is not unfair to assume, in the absence of a contrary allocation, see, e.g., McShane v. Commissioner, 53 T.C.M. (CCH) 409, 1987 WL 40219 (1987), that interest and damages compose the same proportion of the settlement as of the antecedent judgment. Cf. Lyeth v. Hoey, 305 U.S. 188, 196, 59 S.Ct. 155, 83 L.Ed. 119 (1938) (explaining that amounts received in compromise of a claim are treated for tax purposes in the same manner as would have been the case had the taxpayer-plaintiff litigated and won the suit); Alexander v. IRS, 72 F.3d 938, 942 (1st Cir.1995) (similar). That assumption has particular force where, as here, the appeal period had not run and the settlement amount exceeded the amount of the damages recovered. 4 This concatenation of circumstances leaves no doubt but that the settlement includes some prejudgment interest. 18 Our decision two years ago in Delaney paves the way for the result that we reach today. Delaney is particularly instructive with respect to the petitioners' argument that the Commissioner improperly went behind their settlement agreements. We determined there that the court had the right--indeed, the duty--to look beyond the language subscribed to by the parties. Delaney, 99 F.3d at 23; accord Alexander 72 F.3d at 942; Robinson, 70 F.3d at 37-38. 19 Delaney is also instructive on another point. In that case, the taxpayers garnered a jury verdict for $175,000 in a personal injury suit, to which the trial court added $112,000 in statutorily mandated prejudgment interest. See Delaney, 99 F.3d at 22. During the pendency of the ensuing appeal, the parties settled the case for $250,000, without addressing the tax consequences of the settlement in any way. See id. When the Delaneys failed to report any portion of the settlement on their federal income tax return for the appropriate year, the Commissioner constructed a fraction, using as the numerator the amount of prejudgment interest set by the trial court ($112,000) and as the denominator the total amount of the judgment ($287,000). He then multiplied the total settlement ($250,000) by this fraction and assessed a deficiency on the basis that the resulting product ($97,561) represented the (taxable) interest component of the settlement. See id. 20 The Tax Court sustained the Commissioner's determination, as did we. See id. at 23. Specifically, we approved the Commissioner's use of a ratio based on the judgment in apportioning the undifferentiated settlement proceeds as between prejudgment interest and compensatory damages. See id. at 25-26; accord Robinson, 70 F.3d at 38 (holding explicitly that the jury's verdict furnishes the best indication of how to prorate an ensuing settlement). Since the Commissioner used exactly the same methodology in this case, our precedent forecloses the petitioners' complaint about that methodology. 21 Consistent with the authorities we have cited, we hold that when an amount has been received in settlement of a claim after the claim has been reduced to judgment, the judgment, albeit not final, nonetheless furnishes an adequate guideline for allocation by the Commissioner to the extent that it is composed of both compensatory damages and prejudgment interest. See Delaney, 99 F.3d at 25-26; Robinson, 70 F.3d at 38. 22