Opinion ID: 3011559
Heading Depth: 1
Heading Rank: 4

Heading: allocating delay d amages in settlement

Text: Having concluded that delay damages received pursuant to Pennsylvania Rule of Civil Procedure 238 are not exempt from taxation as damages received on account of personal injury, we proceed to whether the District Court allocated the proper measure of delay damages from the total recovery received in settlement. The IRS suggested, and the District Court found, that 46% of the $3.4 million received in settlement was properly allocated to delay damages because that was the same proportion of the trial court's total award apportioned to delay damages. After reducing the taxable income to the amount actually received by the Taxpayers after payment of attorneys' fees and costs,14 the _________________________________________________________________ 14. No party has contested the propriety of the IRS's initial deduction of all legal fees and expenses from the award before determining taxable income. But see Robinson v. Commissioner, 102 T.C. 116, 137 n.15 (1994), (In the case of a settlement that includes damages both includable in income under sec. 61(a) and excludable from income under sec. 104(a)(2), the Court generally determines the deductibility of any underlying legal fees by allocating the fees in the same proportion as the excludable and includable portions of the settlement.) (citing Stocks v. 24 IRS proposed to tax 46% of the net settlement received by the Taxpayers. Using this formula, the IRS determined that $1,033,954 was taxable income.- Before proceeding to the Taxpayers' assignments of error on this point, we note that the taxpayer bears the ultimate burden of proving, by a preponderance of the evidence, that [the IRS's] assessment is erroneous. Sullivan v. United States, 618 F.2d 1001, 1008 (3d Cir. 1980). Because IRS tax assessments are presumed to be correct, [i]t is not enough for [the Taxpayers] to demonstrate that the assessment of the tax for which refund is sought was erroneous in some respects. United States v. Janis, 428 U.S. 433, 440 (1976). Instead, the taxpayer bears the burden of proving the amount he is entitled to recover. Id.; see also Freck v. Internal Revenue Serv., 37 F.3d 986, 992 n.8 (3d Cir. 1994) (IRS tax assessments are generally presumed to be correct). The Taxpayers' burden in this respect is made more difficult by the reasonableness of the IRS's allocation. It is a tenet of federal tax law that income received in settlement of a claim should be taxed in the same manner as if it had been received on that claim in court. See Lyeth v. Hoey, 305 U.S. 188, 196 (1938) (We think that the distinction sought to be made between acquisition through such a judgment and acquisition by a compromise agreement in lieu of such a judgment is too formal to be sound, as it disregards the substance of the statutory exemption.). To maintain tax equality between settlements and court awards, we determine the tax implications of a settlement by ascertaining the obligation or claim initially resolved by judgment in lieu of which the settlement was made. See Alexander v. Internal Revenue Serv., 72 F.3d 938, 942 (1st Cir. 1995); Getty v. Commissioner, 913 F.2d 1486, 1490 (9th Cir. 1990); Raytheon Prod. Corp. v. Commissioner, 144 _________________________________________________________________ Commissioner, 98 T.C. 1, 18 (1992)), aff 'd 70 F.3d 34 (5th Cir. 1995)); Metzger v. Commissioner, 88 T.C. 834, 860 (1987) (same), aff 'd, 845 F.2d 1013 (3d Cir. 1988) (table). Because this issue has not been presented on appeal, we limit our opinion to the propriety of the allocation of net settlement proceeds. 25 F.2d 110, 113 (1st Cir.) (The test is not whether the action was one in tort or contract but rather the question to be asked is `In lieu of what were the damages awarded?' ), cert. denied, 323 U.S. 779 (1944). Because it is the defendant who chooses to pay settlement of the plaintiff 's claims, several courts have held that, in the absence of a written settlement agreement parsing the claims that comprise a general settlement, it is the intent of the payor that is the most persuasive evidence of the nature of claims settled by that party to avoid litigation. See Knuckles v. Commissioner, 349 F.2d 610, 613 (10th Cir. 1965); Agar v. Commissioner, 290 F.2d 283, 284 (2d Cir. 1961); Ray v. United States, 25 Cl. Ct. 535, 540 (1992), aff 'd, 989 F.2d 1204 (Fed. Cir. 1993) (table); Metzger v. Commissioner, 88 T.C. 834, 847 (1987), aff 'd, 845 F.2d 1013 (3d Cir. 1988) (table); Bent v. Commissioner, 87 T.C. 236, 244 (1986), aff 'd, 835 F.2d 67 (3d Cir. 1987); Glynn v. Commissioner, 76 T.C. 116, 120 (1981), aff 'd, 676 F.2d 682 (table) (1st Cir. 1982). If the settlement agreement lacks express language stating that the payment was (or was not) made on account of personal injury, then the most important fact in determining how section 104(a)(2) is to be applied is `the intent of the payor' as to the purpose in making the payment. Metzger, 88 T.C. at 847-48. The Taxpayers aver that the Settlement Agreement in this case lacks any express language parsing the payment of the defendants between personal injury damages and delay damages. Lacking any evidence of allocation in the settlement agreement, they maintain that the only evidence presented to the Court was the affidavit of Don P. Foster, Taxpayers' counsel in the personal injury litigation, in which he asserts that no consideration was given to delay damages in the settlement negotiations and that the tax consequences of the agreement were never considered by the parties. Therefore, their argument proceeds, the District Court erred in refusing to credit the only evidence with which it was presented on the subject of allocation. We are unpersuaded. Because the intent of the payor is paramount in determining the nature of the settled claims, it is admittedly difficult to discern the nature of settled claims in an agreement that fails to distinguish the 26 separate elements of recovery. Yet in situations like this,15 where there has been a judgment in a trial court that preceded settlement of the claims, the most persuasive evidence of the payor's intent in settling the case is the previous damages award of that court. Recognizing this logic, the First Circuit has stated that 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. Rozpad, 154 F.3d at 3-4. This logic is convincing. In Rozpad, two sets of plaintiffs had settled personal injury suits after successfully prosecuting their actions and receiving jury awards for personal injury damages to which prejudgment interest was added by the trial court. Id. at 1. Neither of the settlements allocated the settlement award between personal injury damages and prejudgment interest. Id. The Tax Court rejected plaintiffs' argument that, because the settlement agreement did not allocate between taxable and tax-exempt damages, none of the settlement award was taxable and the First Circuit affirmed. Id. When the parties have settled a claim for a liquidated amount . . . it is not unfair to assume, in the absence of a contrary allocation . . . that interest and damages compose the same proportion of the settlement as of the antecedent judgment. Id. at 4. The IRS and District Court were thus justified in assuming, under the facts of this case, that the proportion of interest to damages reflected that of the preceding _________________________________________________________________ 15. The circumstances of this case do not require us to reach the tax consequences of a personal injury settlement agreed upon before adjudication of the claims in court. Cf. Rozpad v. Commissioner, 154 F.3d 1, 3 (1st Cir. 1998) (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.). 27 judgment. As previously noted, the settlement was for $3.4 million, just fractionally less than the Taxpayers' combined judgment awarded at trial and affirmed on appeal. 16 Thus, the Foster affidavit was not the District Court's only evidence on allocation. It was not even the best evidence. Nor was it error for the District Court to have rejected Foster's assertions that the settlement contained no delay damages. According to the affidavit, settlement amounts were derived at solely from a consideration on behalf of the plaintiffs of the risks to which they would be subjected by refusing to settle the case while an appeal was pending. (emphasis added). This statement is not probative of any fact relevant to our inquiry; instead it is thepayor's intent - the defendants in the Taxpayers' personal injury suit - which is relevant. On the subject of the defendants' intentions, the affidavit states, discussions with defendants' representatives concerned the considerable exposure to a larger verdict[,] in the event defendants prevailed on the their appeal and a new trial was granted[,] because of Mr. Francisco's continuing and worsening condition. This statement does not help the Taxpayers' argument. For even if the defendants were concerned with the possible exposure to a larger damages award on remand, that does not support the inference that the defendants sought to allocate its payments in this settlement entirely to personal injury, as opposed to some pro rata portion of both personal injury damages and delay damages. That is, the defendants' concern with a later, larger judgment supports the inference that they wished to settle sooner for less money; it does not support the inference that they intended only to pay personal injury compensation in the settlement.17 Indeed, if the defendants _________________________________________________________________ 16. Indeed, Foster's affidavit candidly admits that the verdicts were a starting point for settlement negotiations. The verdicts, including Rule 238 damages, were considered only for the purpose of establishing the dollar exposure around which negotiations with defendants centered. 17. Though not the case here, it is possible that parties could allocate contractually the whole of a settlement only to the non-taxable portion of a prior judgment. In McKay v. Commissioner , 102 T.C. 465, 487 (1994), vacated on other grounds, 84 F.3d 433 (5th Cir. 1996) 28 were motivated by their future exposure in the event of a possible new trial, they nonetheless had every reason to believe that any future increased judgment would include increased delay damages commensurate with the increased compensatory damages. Furthermore, even had the District Court accepted the Foster affidavit to establish the proposition that the settlement agreement was intended by the payor to provide no compensation for delay damages, it was within the Court's province to reject that evidence. The general rule is that a trial court may reject the parties' allocation of claims, even when that allocation is contained within the settlement itself. See Delaney v. Commissioner , 99 F.3d 20, 25 (1st Cir. 1996). In Delaney, that court was presented with a $250,000 postjudgment settlement literally allocating nothing to statutory prejudgment interest notwithstanding the $112,000 prejudgment interest component concededly included in the $287,000 superior court judgment. Delaney, 99 F.3d at 24. Faced with a settlement agreement so markedly different in allocation from the underlying judgment, the Tax Court rejected the parties' allocation of the settlement's components and instead substituted, for tax purposes, the IRS's allocation of the ratio of prejudgment interest to the total award. Id. at 25. The First Circuit affirmed the Tax Court's reallocation, holding that it supportably ruled that the [taxpayers] had not overcome the presumption of correctness to which the Commissioner's allocation is entitled, [and that] the allocation of 39% of the settlement amount to statutory _________________________________________________________________ (unpublished), the Tax Court found that the payor's intent was only to compensate the non-taxable libel portion of the jury award and not the taxable punitive damages or civil RICO claims. McKay is distinguishable from the current case because that Court found: (1) the parties were adversarial on the allocation because the plaintiff wished to have damages allocated to the RICO claims; (2) the defendant refused to settle punitive damages and RICO claims; (3) the agreed settlement expressly stated that it did not compensate the plaintiff for the punitive damages and RICO claims; and (4) the resulting settlement of non-taxable, compensatory damages was less than the value of those compensatory claims awarded by the jury. See id. at 484; see also Bagley v. Commissioner, 121 F.3d 393, 397 (8th Cir. 1997) (distinguishing McKay). 29 prejudgment interest, substantially based upon the aforementioned parallelism [to the trial court's award], did not constitute error. Id. at 25-26. In rejecting the settlement's allocation of no value to prejudgment interest, the Court in Delaney relied on cases that established a duty to look beyond the language subscribed to by the parties, and to determine if the presumption of correctness attending the IRS's allocation is overcome. Id. at 23. These cases recognize that parties rarely have a bona fide dispute over the allocation of damages within the settlement agreement, and thus the written allocation may be driven by tax considerations and not reflect the true value of settled claims. See Robinson v. Commissioner, 70 F.3d 34, 37-38 (5th Cir. 1995) (holding that the settling parties were not adversaries in determining the allocation of the settlement for tax purposes and that its 5% allocation to taxable punitive damages, after a sizable punitive damages judgment, was not credible), cert. denied, 519 U.S. 824 (1996); Taggi v. United States, 35 F.3d 93, 96 (2d Cir. 1994) (The Tax Court consistently has stressed the importance of a bona fide dispute over excludable damages.); Threlkeld v. Commissioner, 87 T.C. 1294, 1307 (1986) (the specific allocation contained in the settlement agreement does not necessarily control in deciding whether the claim being settled arises from a personal injury), aff 'd, 848 F.2d 81 (6th Cir. 1988); Glynn v. Commissioner, 76 T.C. 116, 121 (1981) (rejecting the settlement agreement's implication that the settled claims might have been for personal injury when the claims asserted by plaintiff were wholly contractual), aff 'd, 676 F.2d 682 (1st Cir. 1982) (table). It is thus well established that in cases in which the settlement agreement's allocation of damages does not reflect the true nature of the underlying award, the District Court has a duty to look behind the agreement of the parties to discern the true nature of the payor's intent in settling claims. Similarly, when a party, such as the Taxpayers here, asserts that the allocation intended by the payor is different than that contained in the underlying judgment (which, if adopted by the IRS, enjoys a rebuttable presumption status), courts are obliged to measure the veracity of, and support for, that assertion. See Kurowski v. Commissioner, 917 F.2d 1033, 1036 (7th Cir. 1990). 30 Moreover, our review of the District Court's determination of the payor's intent is particularly deferential because it must weigh all of the facts and circumstances in ascertaining the true substance or nature of the claim that was settled. McKay v. Commissioner, 102 T.C. at 482. Questions of what claims the payors intended to settle18 are factual. See Stocks v. Commissioner, 98 T.C. 1, 11 (1992) (The first matter that we must determine is what the settlement settled. This is a factual inquiry.). We will only disturb a court's findings of fact when clearly erroneous. See Coca-Cola Bottling Co. of Elizabethtown, Inc. v. CocaCola Co., 988 F.2d 386, 401 (3d Cir. 1993) (The intent of the parties to ambiguous provisions in a contract is, however, a question of fact that an appellate court can set aside only if it is clearly erroneous.). On the basis of the facts presented, we cannot conclude that the District Court clearly erred in refusing to credit the Taxpayers' assertions that the payor's intent in settling the lawsuit was only to compensate for personal injuries and not the delay damages to which Taxpayers' would be otherwise entitled.19 Having rejected the Taxpayers' assertions on this point, we agree that the District Court correctly concluded that the IRS's use of a ratio method to determine the portion of the settlement allocated to delay damages was correct. Taxpayers have not submitted credible evidence that would _________________________________________________________________ 18. [B]asic contract principles do indeed apply to settlement agreements. In re Cendant Corp. Prides Litig., 233 F.3d 188, 193 (3d Cir. 2000). 19. We find the Tax Court's holding in McShane v. Commissioner, 53 T.C.M. (CCH) 409, 1987 WL 40219 (1987), to be distinguishable. In that case, the jury had awarded personal injury damages, but the trial court had not yet added prejudgment interest and entered an enforceable judgment when the case was settled. See id. Furthermore, the settlement agreement explicitly provided that sums paid werewithout costs and interest. Id. Thus, in light of the pendency of any prejudgment interest, the Tax Court found that the payor's intent was only to compensate plaintiffs for their non-taxable personal injury. See id. In this case, delay damages were added to the jury award in a definite amount and were a component of an enforceable judgment that had already been affirmed once on appeal. It was thus reasonable for the District Court to find that the intentions of the defendants in this case were different from the intentions of the defendants in McShane. See Delaney, 99 F.3d at 25 n.4. 31 rebut, by a preponderance of the evidence, that the defendants' intentions in settling their suit were anything other than to avoid the underlying judgment. Because that judgment contained both personal injury damages and delay damages, the IRS was correct in allocating the settlement similarly. Lastly Taxpayers argue that, if we do not accept their argument that no part of the settlement was allocated to delay damages, the Government should only tax the amount by which the net settlement exceeded the award of damages given by the jury.20 We first note that no court has adopted this methodology for calculating the taxable portion of a settlement recovery.21 The District Court dismissed this methodology out of hand, statingI do not find this argument persuasive. _________________________________________________________________ 20. Subtracting the personal injury award ($1,910,000) from the net settlement received by the Taxpayers ($2,247,727) yields $337,727, which is the amount actually received by the Taxpayers in excess of the jury award. 21. Taxpayers assert that this methodology is consistent with that in Bagley v. Commissioner, 121 F.3d 393 (8th Cir. 1997). In Bagley, the parties settled a defamation suit with a punitive damages component after the Court of Appeals remanded the case to the district court. Id. at 394. Even though the initial judgment on the remanded claim had been for $1 million in compensatory damages and $5 million in punitive damages, the parties settled for $1.5 million prior to trial. Id. Though the IRS had sought to tax a greater amount, the Tax Court found that the payor's intent was to minimize the payment of punitive damages, and thus allocated $1 million to compensatory defamation damages and $500,000 to taxable punitive damages. Id. at 395. The Eighth Circuit rejected the taxpayers' argument that none of the damages were for punitive damages, even though there was some evidence from negotiations in support of that contention. Id. at 395-96. While the allocation in Bagley did result in taxation of only that amount by which the settlement exceeded the jury's compensatory, nontaxable damages, this does not support the Taxpayers in this case because the result in Bagley was intended by the settling parties, as found by the Tax Court after consideration of all relevant circumstances. Id. at 395. In contrast, the Taxpayers have no evidence that any party to this underlying litigation intended such an allocation and instead have suggested this technique as a normative principle, one to which we do not subscribe. 32 Nor do we. The Taxpayers' suggested calculation is initially appealing because it would tax as delay damages only that amount by which their recovery exceeded the jury award. On closer analysis, however, it is apparent that this allocation method assumes that, for some inexplicable reason, the attorneys' fees were deducted only from the delay damages and not in pro rata portions from the Taxpayers' recovery as a whole. Not only is this supposition untenable, but it would also result in a scheme by which the quantity of the judgment that is taxable would turn on the amount of attorneys' fees and costs. The anomalous result would be that plaintiffs identically situated to the Taxpayers but who represented themselves pro se and obtained an identical recovery would pay substantially more taxes on their judgment than the Taxpayers in this case. There is no reason that the tax incidence of a recovery of delay damages should be almost entirely mitigated by attorneys' fees and costs deducted from the recovery. Calculation of taxes is not a reprise of Jarndyce v. Jarndyce, the legendary suit in Charles Dickens' Bleak House, in which resolution came about only because legal fees ate up the whole of an estate. Indeed, the inherently rational and fair method to disaggregate taxable delay damages from non-taxable personal injury damages in a general settlement following a judgment containing both, in the absence of persuasive evidence supporting a contrary allocation, is the ratio method adopted by the IRS and District Court in this case. The IRS's allocation accomplishes the purpose ofS 104(a)(2) by exempting only those damages received in compromise of the personal injury claim while permitting taxation of the Rule 238 damages added to the award to compensate the plaintiff for delay. We therefore affirm the judgment of the District Court awarding summary judgment in favor of the Government on the allocation issue. A True Copy: Teste: Clerk of the United States Court of Appeals for the Third Circuit 33