CHARLES FRANCISCO; CECILIA FRANCISCO, Appellants v. UNITED STATES OF AMERICA
No: 00-1802
UNITED STATES COURT OF APPEALS FOR THE THIRD CIRCUIT
October 1, 2001
Honorable Anita B. Brody
Precedential or Non-Precedential: Docket 00-1802. Argued: February 5, 2001. Before: BECKER, Chief Judge, AMBRO and STAPLETON, Circuit Judges.
On Appeal from the United States District Court for the Eastern District of Pennsylvania (D.C. Civil Action No. 98-2245)
Don P. Foster (Argued) Mary E. O‘Laughlin (Argued) Pepper Hamilton, LLP 18th & Arch Streets 3000 Two Logan Square Philadelphia, PA 19103 Counsel for Appellant
Tamara W. Ashford (Argued) Kenneth W. Rosenberg Bruce R. Ellisen United States Department of Justice Tax Division P.O. Box 502 Washington, DC 20044 Counsel for Appellee
Arthur L. Bugay Galfand Berger 1818 Market Street Suite 2300 Philadelphia, PA 19103 Counsel for Amicus-Appellant Pennsylvania Trial Lawyers Association
AMBRO, Circuit Judge.
This tax case presents two questions. First, are “delay damages,” received by the plaintiff in a personal injury tort action pursuant to
We hold that the personal injury exemption of
I. FACTS
Charles Francisco and his wife Cecilia (collectively, the “Taxpayers“) brought an action in the Court of Common Pleas of Philadelphia County to recover damages for personal injuries Mr. Francisco sustained in a 1983 automobile accident.1 In March 1994, a jury returned a verdict in favor of the Taxpayers -- awarding Mr. Francisco $1,810,000 in damages and Mrs. Francisco $100,000 for loss of consortium. Delay damages in the amount of $1,615,662 were then added to that award2 by the court pursuant to
While the defendants’ petition to the Pennsylvania Supreme Court for allowance of appeal was pending, the parties agreed to and executed a Settlement Agreement and Release (the “Settlement Agreement“) on January 19, 1996. The Settlement Agreement provided for payment to the
The Taxpayers did not include any of the $3,400,000 settlement as income on their 1996 tax return. The Internal Revenue Service (the “IRS“) audited the Taxpayers and assessed a tax deficiency of $402,646.4 The deficiency was calculated by first determining what component of the net settlement recovery represented delay damages. The IRS assumed that 46% of the recovery was taxable as delay damages because 46% was the same ratio of delay damages ($1,615,662) to the total award ($3,526,462) awarded to the Taxpayers in court. It then multiplied the net recovery of the Taxpayers ($2,247,727) by 46% and concluded that $1,033,954 of the settlement was taxable as delay damages. The IRS assessed a deficiency of $402,646 on the $1,033,954 in taxable income received by the Taxpayers.
II. JURISDICTION
The Taxpayers paid the deficiency, with interest, and then filed a timely claim with the IRS for a refund on March 17, 1998. See
On June 22, 1999, the District Court ruled that delay damages were taxable and granted part of the Government‘s motion for summary judgment. The Court declined to address what portion of the settlement should be properly allocated to delay damages and requested further briefing on the subject. On May 25, 2000, the District Court granted final judgment in favor of the Government after concluding that the IRS‘s method of apportioning the delay damages was proper.
This Court has jurisdiction over the Taxpayers’ timely appeal of both rulings pursuant to
III. TAXABILITY OF DELAY DAMAGES
A.
Gross income is defined for purposes of the Internal Revenue Code (the “Code“) in
Taxpayers assert that the entire proceeds of the settlement are exempt from income under the personal injury exemption,
It is undisputed that Taxpayers’ underlying jury award was for a tort or tort type rights and that those damages were received on account of personal injury. “For damages to be excludable under section 104(a)(2), the taxpayer‘s underlying claim must be for tortlike personal injury.” Kovacs v. Commissioner, 100 T.C. 124, 127 (1993) (citing Burke, 504 U.S. at 233). We are presented with the more exacting questions of whether delay damages added to the underlying award by the Pennsylvania court pursuant to Rule 238 are “based upon tort or tort type rights” and whether they were received “on account of ” a personal injury. Schleier, 515 U.S. at 337. Resolution of these questions requires us to examine the genesis of
The principle underlying
Obviously, we cannot determine whether delay damages make a victim whole or return the victim‘s personal or financial capital without understanding the purpose served by delay damages under Pennsylvania law. This is not to say, however, that we are deciding an issue of state law. While Pennsylvania law describes the character of the legal right to delay damages, the tax consequences of the Taxpayers’ receipt of delay damages are governed solely by federal law, in this case the considerations underlying
Notes
B.
To ascertain the character of delay damages awarded pursuant to Rule 238, we must begin with a discussion of prejudgment interest in Pennsylvania common law.
Traditionally, prejudgment interest, also called “interest eo nomine,”6 was only available when a fixed or liquidated sum was due on a certain date. See Pollice v. Nat‘l Tax Funding, L.P., 225 F.3d 379, 395 (3d Cir. 2000). “Interest, as such, is recoverable only where there is a failure to pay a liquidated sum, due at a fixed day, and the debtor is in absolute default.” Citizens’ Natural Gas Co. v. Richards, 18 A. 600 (Pa. 1889). In these contractual cases, prejudgment interest “is a matter of right and is calculated from the time the money becomes due or payable.” American Enka Co. v. Wicaco Mach. Corp., 686 F.2d 1050, 1056 (3d Cir. 1982); see also Penneys v. Pennsylvania R.R. Co., 183 A.2d 544, 546 (Pa. 1962) (citing Restatement (First) of Contracts S 337); Palmgreen v. Palmer‘s Garage, 117 A.2d 721, 722 (Pa. 1955); Frank B. Bozzo, Inc. v. Electric Weld Div. of Fort Pitt Div. of Spang Indus., Inc., 498 A.2d 895, 898 (Pa. Super. Ct. 1985).
Yet Pennsylvania law did not completely deny to tort victims a remedy for the passage of time. In Citizens’ Natural Gas Co. v. Richards, the Pennsylvania Supreme Court established that in some property tort cases, such as “unintentional conversion or destruction of property,” prejudgment interest may be awarded. 18 A. at 600. The Court explained:
Into these cases the element of time may enter as an important factor, and the plaintiff will not be fully compensated unless he receive not only the value of his property, but receive it, as nearly as may be, as of the date of his loss. Hence it is that the jury may allow additional damages in the nature of interest for the
lapse of time. It is never interest as such, nor as a matter of right, but compensation for the delay, of which the rate of interest affords the fair legal measure.
Id. The award of such “compensation for delay” in property torts “is not a matter of right but is an issue for the finder of fact, the resolution of which depends upon all the circumstances of the case.” Marrazzo v. Scranton Nehi Bottling Co., 263 A.2d 336, 337 (Pa. 1970); see also American Enka Co., 686 F.2d at 1056. Under either theory, “interest” or “compensation for delay,” the plaintiff was compensated at the statutory legal rate of interest of six percent from the date the cause of action accrued. See American Enka Co., 686 F.2d at 1057;
However, neither prejudgment interest nor “compensation for delay” was awarded for personal injuries under the common law in Pennsylvania. Conover v. Bloom, 112 A. 752 (Pa. 1921). “Where real property has been taken, injured, or destroyed, [compensation for delay] . . . is an allowable element, and the same is true where the damage is inflicted upon personal property; . . . but not where the claim is for personal injuries, for then the damages are assessed as of the date of the trial, and not of the injury.” Id. at 752 (citations omitted); see also Witmer v. Bessemer & L.E.R. Co., 88 A. 314, 315 (Pa. 1913); McGonnell v. Pittsburgh Rys. Co., 83 A. 282, 283 (Pa. 1912) (“In a personal injury case the damages are assessed as of the date of the trial and not of the injury. Hence there can be no general compensation for delay.“); Pittsburgh S. Ry. Co. v. Taylor, 104 Pa. 306, 317 (1883) (in a personal injury action, “[i]t was also error to permit the jury to allow interest from the date of the accident to the time of trial upon the amount they might ascertain plaintiff ‘s damages to have been“). Thus at common law in Pennsylvania a victorious plaintiff was only entitled to interest from the date of the claim‘s accrual if that claim arose as a contractual obligation for a fixed sum due on a particular date or if the claim resulted from tortious damage to property. No party to this case has brought to our attention any actions in which prejudgment interest or compensation for delay was granted on a personal injury award prior to the enactment of Rule 238.
Pennsylvania Rule of Civil Procedure 238 was enacted in 1978 to provide successful plaintiffs in actions for damages for personal or property injuries with compensation for the delay preceding judgment. Its primary provision states:
At the request of the plaintiff in a civil action seeking
monetary relief for bodily injury, death or property damage, damages for delay shall be added to the amount of compensatory damages awarded against each defendant or additional defendant found to be liable to the plaintiff in the verdict of a jury, in the decision of the court in a nonjury trial or in the award of arbitrators . . . , and shall become part of the verdict, decision or award.
Because the damages awarded pursuant to Rule 238 are determined by reference to prevailing interest rates, Pennsylvania courts have frequently characterized the rule as providing for “prejudgment interest.”7 In one of the first
Having concluded that Rule 238 permits the awarding of prejudgment interest, we must recognize one caveat. As the Taxpayers’ repeatedly assert, delay damages are not available to all successful tort plaintiffs as a matter of right, but can only be awarded either when the defendant did not make a reasonable settlement offer or for periods of time for which the plaintiff is not responsible for causing delay. See Schrock v. Albert Einstein Med. Ctr., 589 A.2d 1103, 1107 (Pa. 1991). Delay damages thus serve a secondary purpose to hasten the settlement and conduct of tort actions. See
In making a decision on a plaintiff ‘s entitlement to delay damages[,] the mere length of time between the starting date and the verdict is not to be the sole criterion. The fact finder shall consider: the parties’ respective responsibilities in requesting continuances[;] the parties’ compliance with rules of discovery; the
respective responsibilities for delay necessitated by the joinder of additional parties; and other pertinent factors.
Craig v. Magee Memorial Rehabilitation Ctr., 515 A.2d 1350, 1353 (Pa. 1986). The Pennsylvania Supreme Court has described these considerations as “procedural fault.” Costa, 626 A.2d at 570. “The considerations that the Craig court listed as relevant to fault are all factors relevant to the delay of trial.” Id. Rule 238 thus exists as a hybrid prejudgment interest statute, attempting to make whole the tort victim who has been denied use of his or her money rightfully due when the cause of action accrued, but conditioning the grant of that remedy on the parties’ relative “procedural fault” in delaying adjudication of the underlying tort.
Three other courts of appeals have addressed whether prejudgment interest on a personal injury award is entitled to exemption from taxation pursuant to
In Kovacs, the first of the prejudgment interest cases, the Tax Court parsed the traditional distinction between “damages” and “interest” and noted that “damages are the principal sum on which the interest is owed, and ordinary usage suggests the two are separate.” Kovacs, 100 T.C. at 129. The Court went on to cite extensively from the long tradition of taxing postjudgment interest without regard to the fact that it was earned on a personal injury award. See id.; see also Aames v. Commissioner, 94 T.C. 189 (1990) (“The nature of interest is that it is paid because of delay in
The Tenth Circuit in Brabson was critical of the Kovacs opinion‘s overt reliance on the labels “damages” and “interest” in determining the taxability of prejudgment interest. Brabson, 73 F.3d at 1045. Brabson‘s rejection of Kovacs was due, in part, to the fact that the Colorado Supreme Court had characterized prejudgment interest as a component of damages, thus blurring meaningful
First, it noted that “[p]rejudgment interest was rarely available under the common law, and never for personal injuries.” Brabson, 73 F.3d at 1046. Because the common law in Colorado had never provided for prejudgment interest on personal injuries until the amendment of
Secondly, the Tenth Circuit in Brabson recognized that delay damages did not fit easily within the human capital rationale that underlies
Lastly, the First Circuit in Rozpad, 154 F.3d at 5-7, neatly synthesized the Kovacs and Brabson decisions. The Court agreed with the conclusion in Kovacs that there is no distinction between prejudgment and postjudgment interest.
It is true that many of the cases discussed in Kovacs deal with post-judgment interest--but the petitioners fail to persuade us that this distinction makes a meaningful difference. Interest, whether pre- or post-judgment, compensates for delay in payment, and is specifically included in the litany of income items subject to taxation under section 61.
Rozpad, 154 F.3d at 5. The First Circuit also credited Brabson‘s application of the second requisite showing
We discern no meaningful distinction between delay damages received pursuant to Rule 238 and the prejudgment interest statutes in cases such as Kovacs, Brabson and Rozpad.11 The common law in Pennsylvania is no different from that in Colorado or Rhode Island with respect to prejudgment interest. Personal injury plaintiffs in neither of these states were entitled to prejudgment interest as a component of their remedy at the common law. See Conover, 112 A. at 752 (Pennsylvania); Brabson, 73 F.3d at 1046 (Colorado); Rozpad, 154 F.3d at 7 (Rhode Island). Prejudgment interest in personal injury cases
was unheard-of in 1919 when Congress enacted the direct lineal ancestor of section 104(a)(2), section 213(b)(6) of the Revenue Act of 1918, ch. 18, 40 Stat. 1057, 1066 (1919). Since the exclusion for personal injury awards has been handed down almost verbatim from 1919 forward, Congress could not conceivably have intended the exclusion to apply to prejudgment interest.
Rozpad, 154 F.3d at 7. As noted above, the Supreme Court used similar reasoning in concluding that FELA, enacted in 1908, did not provide for the award of prejudgment interest because the common law did not allow for it and it was “unpersuaded that Congress intended to abrogate that doctrine sub silentio.” Monessen, 486 U.S. at 337-38 (concluding that Pennsylvania courts may not award prejudgment interest pursuant to Rule 238 in FELA actions). We must similarly conclude that Congress did not
The Taxpayers’ attempts to argue otherwise are unpersuasive. They would have us draw a distinction between “interest,” awarded as of right for the failure to pay a liquidated sum on a fixed day, and “compensation for delay,” which was sometimes available in property torts such as “unintentional conversion or destruction of property.” Citizens’ Natural Gas Co., 18 A. at 600. From this distinction, the Taxpayers argue that while interest was not awarded in personal injury cases at the common law, “compensation for the delay” was awarded when the circumstances demanded, and thus it is proper to assume that the award of “compensation for the delay” should be exempted from taxation. This argument is unpersuasive for two reasons. One, this Court has previously noted that the distinction between “interest” and “compensation for the delay” is minimal -- “a charming legal fiction, in the true ancient Roman ficto, fictiones, sense.” American Enka, 686 F.2d at 1056. Two, even acknowledging the distinction between “interest” and “compensation for the delay,” neither of these theories of recovery would have entitled the Taxpayers in this case to the recovery of prejudgment interest prior to the enactment of Rule 238 because neither extended to personal injuries. See Conover, 112 A. at 752; Witmer, 88 A. at 315; McGonnell, 83 A. at 283; Pittsburgh S. Ry. Co. 104 Pa. at 317. Thus, irrespective of any distinction between “interest” and “compensation for delay,” the common law history in Pennsylvania is no different than that announced in Brabson:
Prejudgment interest was rarely available under the common law, and never for personal injuries. . . . The requirement of a liquidated sum, `fixed and known,’ posed the greatest obstacle towards recovery of such interest.
Thus prejudgment interest, when awarded at all, generally compensated for pecuniary harms, most often easily determinable contractual ones. It is only more recently, pursuant to certain statutes, that prejudgment interest has become recoverable in personal injury suits on nonpecuniary harms.
Brabson, 73 F.3d at 1046. Lacking any basis in common law for the award of prejudgment interest, in any form, for cases such as the Taxpayers‘, it cannot be said that Congress, in enacting
In contrast, it is well established that the exclusion for personal injury was intended to exempt from income damages that “substitute for any normally untaxed personal (or financial) quality, good, or `asset.’ ” O‘Gilvie, 519 U.S. at 86. The Supreme Court recognized in O‘Gilvie that the “human-capital” rationale is founded on tax equality, that is, establishing that an injured person is no better or worse off, from a tax perspective, as a similar person who had not been injured. Id. (holding that punitive damages are not received “on account of ” a personal injury); see also Glenshaw Glass, 348 U.S. at 433 n.8 (“Damages for personal injury are by definition compensatory only.“). While the Court in O‘Gilvie recognized that
While Taxpayers repeatedly assert that delay damages are intended to make a victim whole, see Costa, 626 A.2d at 569 (“the `essence of this duty’ was merely to extend the `compensatory damages necessary to make a plaintiff whole’ “), we must recognize that the purpose they serve is more specific than that simple generalization. As stated in
As noted in Kovacs, since the 1933 case of Riddle v. Commissioner, interest received after judgment is taxable. See Kovacs, 100 T.C. at 129. “Since Riddle, the exclusion for personal injury damages has been reenacted and amended numerous times. Nevertheless, the statute continues to exclude only `damages’ and omits any mention of `interest‘. This implies a continuing acceptance by Congress of the existing interpretation of the exclusion.” Id. at 130.
We are unable to divine a meaningful distinction between postjudgment interest and delay damages. Both compensate the plaintiff for the delay in payment of the principal - the jury‘s damage award. See Rozpad, 154 F.3d at 5. Unless the intervention of the judgment somehow changes the nature of that additional compensation, delay damages or prejudgment interest should be taxable in the same way as postjudgment interest. See
Taxpayers distinguish Rule 238 delay damages from interest generally because they are not awarded in every case as a matter of right, but instead only when the defendant caused delay or failed to make a reasonable settlement offer. See Laudenberger, 436 A.2d at 151 (“[T]his rule serves to compensate the plaintiff for the inability to utilize finds rightfully due him“). Their argument posits that the harm caused to the plaintiffs by delay in receiving compensation for their injury is a separate wrong that Pennsylvania has chosen to compensate with damages. They argue that Pennsylvania courts have established that Rule 238 protects “the personal right of the plaintiff to have his day in court and not to suffer the increment to the
We find this argument unavailing because the Taxpayers cannot establish that a remedy for the harm incurred in this respect is based on “tort” or “tort-like” rights.12 See Schleier, 515 U.S. at 335. There is no doubt that the Taxpayers suffered some difficulties and harms resulting from the delay of more than ten years in receiving recompense for the automobile accident, but “[t]he fact that [an action] causes harm to individuals does not automatically imply, however, that there exists a tort-like `personal injury’ for purposes of federal income tax law.” United States v. Burke, 504 U.S. 229, 238 (1992). Instead, the Supreme Court in Burke emphasized the consideration of traditional tort principles in evaluating the
Recognizing that the narrow remedial scheme of Rule 238 is persuasive evidence that delay damages are not based in tort or tort-type rights, Taxpayers argue that delay damages should be analogized to liquidated damages that serve a compensatory function. The Supreme Court noted in Schleier, while discussing the taxability of the liquidated
Nor is our conclusion that delay damages are not included within the scope of
The passage on which Taxpayers rely states in its relevant portion that “[i]f an action has its origin in a physical injury or physical sickness, then all damages (other than punitive damages) that flow therefrom are treated as payments received on account of physical injury or physical sickness.” H.R. Rep. No. 104-586 at 143-44 (1996) (emphasis added). We ignore for the moment that the 1996 amendments are inapplicable to the Taxpayers’ action. Their argument is that the use of “all damages . . . that flow therefrom” indicates a congressional intent to expand
This is unpersuasive for two reasons. One, the House Report on which the Taxpayers rely does not mention interest at all, but instead was intended to emphasize that damages for emotional distress, defamation, discrimination and other non-physical torts do not result in tax-exempt recoveries under
Having considered both the language of
IV. ALLOCATING DELAY DAMAGES IN SETTLEMENT
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
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 F.2d 110, 113 (1st Cir.) (“The test is not whether the action
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
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
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 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 the “payor‘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
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 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 (table) (1st Cir. 1982).
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).
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. Coca-Cola 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
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, stating “I do not find this argument persuasive.”
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 of
A True Copy:
Teste:
Clerk of the United States Court of Appeals for the Third Circuit