                                                                                                                           Opinions of the United
2001 Decisions                                                                                                             States Court of Appeals
                                                                                                                              for the Third Circuit


10-1-2001

Francisco v. USA
Precedential or Non-Precedential:

Docket 00-1802




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Filed October 1, 2001

UNITED STATES COURT OF APPEALS
FOR THE THIRD CIRCUIT

No: 00-1802

CHARLES FRANCISCO; CECILIA FRANCISCO,
       Appellants

v.

UNITED STATES OF AMERICA

On Appeal from the United States District Court
for the Eastern District of Pennsylvania
(D.C. Civil Action No. 98-2245)
District Judge: Honorable Anita B. Brody

Argued: February 5, 2001

Before: BECKER, Chief Judge, AMBRO and STAPLETON,
Circuit Judges

(Filed: October 1, 2001)

       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

OPINION OF THE COURT

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 Pennsylvania Rule of Civil Procedure
238, exempt from federal income taxation as damages
"received on account of " a personal injury? 26 U.S.C.
S 104(a)(2). Second, if delay damages are taxable, how
should their amount be determined when the plaintiff has
agreed to a post-verdict settlement that fails to allocate the
recovery between compensation for the injury and delay
damages?

We hold that the personal injury exemption of 26 U.S.C.
S 104(a)(2) does not extend to "delay damages" under
Pennsylvania Rule of Civil Procedure 238 and thus the
recovery of those damages by taxpayers is taxable. While we
acknowledge the practical difficulty of determining delay
damages when they are subsumed as an unidentified
component of a comprehensive settlement agreement, we
nonetheless conclude that the District Court reasonably
found delay damages to be an element of the settlement at
issue in this case. We therefore affirm its judgment.

                               2



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 Pennsylvania Rule of Civil Procedure 238,
resulting in a total judgment in favor of the taxpayers of
$3,525,662.3 The defendants in the personal injury action
appealed to the Pennsylvania Superior Court, which
affirmed the trial court's judgment in July 1995.

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
Taxpayers of $3,400,000 in exchange for releasing the
defendants from liability. It contained no admission of
liability and was entered "for the sole purpose of avoiding
further costly litigation." Taxpayers' counsel later submitted
an affidavit to the District Court in this action explaining
that neither the payment of "prejudgment interest" nor the
tax consequences of the settlement was considered during
settlement negotiations. Instead, he suggested that the
verdicts "were considered only for the purpose of
establishing the dollar exposure around which negotiations
_________________________________________________________________

1. The facts of this case are undisputed and are taken from the
Stipulation of Uncontested Material Facts agreed by the parties before
the District Court.

2. Delay damages were awarded on Mr. Francisco's personal injury
award and not the loss of consortium claim. Under Pennsylvania law,
delay damages are not available for loss of consortium. See Anchorstar
v. Mack Trucks, Inc., 620 A.2d 1120, 1121 (Pa. 1993).

3. The Stipulation of Uncontested Material Facts appears to have
excluded Mrs. Francisco's consortium award in its calculation of the
"total award" of $3,425,662.

                                3



with defendants centered. No specific part of the verdicts
was considered in establishing interest as a component of
the settlement." After attorneys' fees and costs were
subtracted, the Taxpayers received $2,247,727.

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 26 U.S.C. S 6511(a). The IRS denied their
administrative claim and Taxpayers brought this refund
suit against the Government in the United States District
Court for the Eastern District of Pennsylvania. Because the
suit was filed within two years of the IRS's denial of their
claim, it was timely. See 26 U.S.C. S 6532(a)(1). Jurisdiction
in the District Court was proper pursuant to 26 U.S.C.
S 7422(a) and 28 U.S.C. S 1346(a)(1).

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
_________________________________________________________________

4. Though Pennsylvania Rule of Civil Procedure 238 has been in effect
since 1979, we know of no prior case in which the IRS has sought to tax
delay damages received under this Rule.

                               4



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 28 U.S.C. S 1291. The
District Court's grant of summary judgment in favor of the
Government is entitled to plenary review by this Court. See
Greenberg v. United States, 46 F.3d 239, 242 (3d Cir.
1994).

III. TAXABILITY OF DELAY DAMAGES

A.

Gross income is defined for purposes of the Internal
Revenue Code (the "Code") in 26 U.S.C. S 61. That section
states that "[e]xcept as otherwise provided in this subtitle,
gross income means all income from whatever source
derived." 26 U.S.C. S 61(a). The statute provides an
illustrative list of various sources of income. One example
is "(4) Interest." 26 U.S.C. S 61(a)(4). The Supreme Court
has long acknowledged the comprehensiveness of defining
income in this manner. "The broad sweep of this language
indicates the purpose of Congress to use the full measure
of its taxing power . . . ." Helvering v. Clifford, 309 U.S. 331,
334 (1940); see also Commissioner v. Glenshaw Glass Co.,
348 U.S. 426, 432 (1955) ("The definition of gross income
has been simplified, but no effect upon its present broad
scope was intended."). Given the breadth of S 61, it is
undoubtedly true that the Taxpayers' recovery is gross
income under this definition and they do not argue
otherwise. This Court has held that "any accession to
wealth is presumed to be gross income, unless the taxpayer
can demonstrate that the accession fits into one of the
specific exclusions created by other sections of the" Code.
Rickel v. Commissioner, 900 F.2d 655, 657-58 (3d Cir.
1990) (citing Glenshaw Glass, 348 U.S. at 429-30). The
question is how much of the Taxpayers' increase in wealth
is specifically exempted from income by other provisions of
the Code.

                               5



Taxpayers assert that the entire proceeds of the
settlement are exempt from income under the personal
injury exemption, 26 U.S.C. S 104(a)(2). In 1996, that
exception excluded from taxation "the amount of any
damages (whether by suit or agreement and whether as
lump sums or as periodic payments) on account of personal
injuries or sickness." Id. The Supreme Court has noted that
the effect of the broad construction of S 61's definition of
gross income is that "exclusions from income must be
narrowly construed." United States v. Burke , 504 U.S. 229,
248 (1992). For that reason, courts interpreting the
personal injury exception have required a two-part showing
by taxpayers. "First the taxpayer must demonstrate that
the underlying cause of action giving rise to the recovery is
`based upon tort or tort type rights'; and second, the
taxpayer must show that the damages were received`on
account of personal injuries or sickness.' " Commissioner v.
Schleier, 515 U.S. 323, 337 (1995).

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 ofS 104(a)(2).

The principle underlying S 104(a)(2) is known as the
"human capital" rationale. As recently explained in O'Gilvie
v. United States, 519 U.S. 79, 84 (1996), it has its roots in
several early tax opinions of the Supreme Court
establishing "the principle that a restoration of capital was
not income." Id.; see Doyle v. Mitchell Bros. Co., 247 U.S.
179, 187 (1918); Southern Pac. Co. v. Lowe, 247 U.S. 330,
335 (1918). The statute that eventually became S 104(a)(2)
resulted from an extension of the restoration of capital
principle to personal injuries. As an Opinion of the Attorney

                               6



General described it, a recovery for personal injury"merely
take[s] the place of capital in human ability which was
destroyed by the accident." 31 Op. Atty. Gen. 304, 308
(1918) (cited in O'Gilvie, 519 U.S. at 85). This
replenishment of human capital, in the form of damages,
"aim[s] to substitute for a victim's physical or personal well-
being -- personal assets that the Government does not tax
and would not have taxed had the victim not lost them."
O'Gilvie, 519 U.S. at 86. The Supreme Court recently
emphasized the importance of fidelity to the human capital
rationale, the "original moorings" of S 104(a)(2). "This
history and the approach it reflects suggest there is no
strong reason for trying to interpret the statute's language
to reach beyond those damages that, making up for a loss,
seek to make a victim whole, or, speaking very loosely,
`return the victim's personal or financial capital.' " Id.

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
S 104(a)(2).5 See Helvering v. Stuart, 317 U.S. 154, 162
(1942); Lyeth v. Hoey, 305 U.S. 188, 194 (1938). "A court
therefore must look first to state law to ascertain the
existence and nature of the interests [the IRS wishes to
tax]. While state law creates legal interests and defines their
incidents, `the ultimate question whether an interest thus
created and defined falls within a category stated by a
Federal statute requires an interpretation of that statute,
which is a Federal question.' " 21 W. Lancaster Corp. v.
Main Line Rest., Inc., 790 F.2d 354, 356 (3d Cir. 1986)
(applying this principle to IRS tax liens) (citations omitted).
_________________________________________________________________

5. Because the role of state law in this inquiry is merely to describe the
nature of the interest being taxed, and because we believe the nature of
the interest created by Rule 238 to be settled in Pennsylvania law, we
decline the Taxpayers' invitation to certify questions to the Pennsylvania
Supreme Court. See 210 Pa. Code S 63.10.
                               7



Having recognized the function state law serves in
informing our judgment, we proceed to discuss the nature
of delay damages under Pennsylvania law.

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
_________________________________________________________________

6. The English translation is "interest under that name."

                               8
       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; Pa. Stat. Ann. tit.
41, S 202 (2000).

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.

                               9



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.

Pa. R. Civ. P. 238(a)(1). It goes on to award damages in an
amount that "shall be calculated at the rate equal to the
prime rate as listed in the first edition of the Wall Street
Journal published for each calendar year for which the
damages are awarded, plus one percent, not compounded."
Pa. R. Civ. P. 238(a)(3). These "delay damages" are only
available to certain plaintiffs and for certain periods of
delay. Delay damages are unavailable during periods in
which the plaintiff caused delay of the trial or if the
defendant made a reasonable written settlement offer and
the plaintiff did not recover more than 125 percent of that
offer after trial. Pa. R. Civ. P. 238(b).

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
_________________________________________________________________

7. Taxpayers argue that delay damages available under Rule 238 are not
"prejudgment interest" and those cases which have so described the rule
"suffer from . . . inattention to detail." Taxpayers' Opening Br. at 19.
Given the sheer quantity of cases that have characterized Rule 238
damages as prejudgment interest, we find this argument to be meritless.
See, e.g., Weber v. GAF Corp., 15 F.3d 35, 36 (3d Cir. 1994) ("Under
Pennsylvania Rule of Civil Procedure 238, a prevailing plaintiff in a
Pennsylvania tort action may receive what amounts to prejudgment
interest on a compensatory damage award."); Simmons v. City of
Philadelphia, 947 F.2d 1042, 1088 (3d Cir. 1991) ("In Savarese, we held
that, because the application of state substantive law providing for

                               10



cases addressing the Rule, the Pennsylvania Supreme
Court described it as follows. "Rule 238 pertains to
prejudgment interest granted in certain instances to
plaintiffs who receive jury verdicts in excess of any
settlement offer made by a defendant prior to trial."
Laudenberger v. Port Auth. of Allegheny County, 436 A.2d
147, 149 (Pa. 1981). The Court recognized that the rule's
source was Pennsylvania's common law heritage of allowing
prejudgment interest "in cases concerning liquidated
damages and breach of contract cases," and "to recover
compensation for delay in payment after loss in tort cases."
Id. at 154. Nevertheless, the Court noted that Rule 238
extended those doctrines and "undeniably imposes an
additional duty upon defendants in the form of
prejudgment interest." Id. "Rule 238 provides compensation
to a plaintiff for delay in receiving the monetary damages
owing as a result of a defendant's tort. This serves to
indemnify the plaintiff for the money he would have earned
on his award if he had promptly received it." Id. at 154. It
is thus transparently clear that Rule 238 established a new
duty for defendants to provide additional compensation to
plaintiffs -- not as additional damages for their injury --
but to remedy the time value of their award lost during the
_________________________________________________________________

prejudgment interest would destroy the uniformity of damages in federal
civil rights cases, Rule 238 does not apply to damages awarded under
section 1983.") (citing Savarese v. Agriss , 883 F.2d 1194 (3d Cir.
1989));
Yohannon v. Keene Corp., 924 F.2d 1255, 1263-64 (3d Cir. 1991) ("the
assessment of pre-judgment interest, sometimes called delay damages");
Trude v. Martin, 660 A.2d 626, 635-36 (Pa. Super. Ct. 1995) ("This result
logically obtains from the new Rule which, while labelled "delay
damages," is really in the nature of prejudgment interest to be added to
compensatory damages awarded at verdict."); Hodges v. Rodriquez, 645
A.2d 1340, 1349 (Pa. Super. Ct. 1994) ("The Laudenberger Court equated
delay damages with prejudgment interest."); Moran v. G. & W.H. Corson,
Inc., 586 A.2d 416, 426 (Pa. Super. Ct. 1991) ("In effect, Rule 238
provides for the award, in appropriate cases, of prejudgment interest.");
Tindal v. SEPTA, 560 A.2d 183, 189 (Pa. Super. Ct. 1989) ("the new Rule
which, while labelled [sic] "delay damages," is really in the nature of
pre-
judgment interest to be added to compensatory damages awarded at
verdict"); Snelsire v. Moxon, 557 A.2d 785, 787 (Pa. Super. Ct. 1989)
("Damages awardable under Rule 238 have been held to be in the nature
of prejudgment interest.").

                               11



period preceding judgment. See Costa v. Lauderdale Beach
Hotel, 626 A.2d 566, 569 (Pa. 1993).8

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
Laudenberger, 436 A.2d at 151. "Delay damages are
incentive to settle and to avoid delay of trial . . . because
the defendant may limit the size of the compensation award
by settling the case or by choosing not to engage in dilatory
pretrial tactics." Costa, 626 A.2d at 570. In this context,
Rule 238 serves two related purposes. "Undeniably, [Rule
238] serves to compensate the plaintiff for the inability to
utilize funds rightfully due him, but the basic aim of the
rule is to alleviate delay in the disposition of cases, thereby
lessening congestion in the courts." Laudenberger, 436 A.2d
at 151. To accomplish that aim, the Pennsylvania courts do
not apply Rule 238 without regard for the defendant's fault
in hampering early settlement and adjudication. 9

       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
_________________________________________________________________

8. "Conversely, delay damages also prevent a defendant from being
unjustly enriched by keeping the interest that could be earned during
the litigation process on what is essentially the plaintiff 's money." See
Costa, 626 A.2d at 569 n.6 (citations omitted).

9. Indeed, following the decision in Craig v. Magee Memorial
Rehabilitation Ctr. Rule 238 was amended to ensure that delay damages
turned on fault by eliminating those provisions that granted delay
damages automatically and replacing them with a hearing on the parties'
fault as discussed in Craig. See Pa. R. Civ. P. 238, Explanatory
Comment--1988.

                               12



       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.
C.

Three other courts of appeals have addressed whether
prejudgment interest on a personal injury award is entitled
to exemption from taxation pursuant to 26 U.S.C.
S 104(a)(2) because it is received "on account of " personal
injury. See Rozpad v. Commissioner, 154 F.3d 1, 6 (1st Cir.
1998) (discussing R.I. Gen. Laws S 9-21-10 (1985)); Brabson
v. United States, 73 F.3d 1040, 1047 (10th Cir.) (discussing
Colo. Rev. Stat. S 13-21-101(1) (1979)), cert. denied, 519
U.S. 1039 (1996); Kovacs v. Commissioner, 100 T.C. 124,
130 (1993) (discussing Mich. Comp. Laws S 600.6013
(1987)), aff 'd without opinion, 25 F.3d 1048 (6th Cir.), cert.
denied, 513 U.S. 963 (1994). All have found that
prejudgment interest is taxable.

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

                                13



the receipt of funds, in this case the principal amount
awarded to plaintiff and designated `damages' by the
Massachusetts Supreme Judicial Court. As interest, it is
taxable to petitioner."); Riddle v. Commissioner, 27 B.T.A.
1339, 1341 (1933) ("The rule that we draw from the above
cases is that interest is properly allowable [as income] upon
a judgment or award of damages for personal injuries when
the amount of the damages has been ascertained and
reduced to judgment."). Lacking any indication in Michigan
law that prejudgment interest should be considered
differently from "interest" generally, the Court concluded
that prejudgment interest was not exempted from income
simply because it was earned on a personal injury award,10
and the Sixth Circuit affirmed. Kovacs, 100 T.C. at 131.

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
distinction between the two concepts. See Allstate Ins. Co.
v. Starke, 797 P.2d 14, 19 (Colo. 1990) ("prejudgment
_________________________________________________________________

10. We reject the argument proffered by the dissent in Kovacs, and
suggested by the Taxpayers here, that the Periodic Payment Settlement
Act of 1982, Pub. L. 97-473, S 101, 96 Stat. 2605 (1982) -- which added
the phrase "and whether as lump sums or periodic payments" after the
clause "whether by suit or agreement" in S 104(a)(2) -- was also intended
by Congress to make all receipts of interest on personal injury awards
nontaxable. See Kovacs, 100 T.C. at 134-35 (Halpern, J., dissenting). As
has been frequently noted, neither the text of the statutory language nor
its legislative history, S. Rep. No. 97-646, at 8 (1982) ("This provision
is
intended to codify, rather than change, present law"), supports the
dissent's position that Congress intended substantive changes to the
treatment of interest in S 104(a)(2). See Rozpad, 154 F.3d at 5 ("[I]t
seems likely that Congress's decision not to tax periodic payments
reflects recognition of the administrative difficulties of such a task--
and
nothing more."); Brabson, 73 F.3d at 1045 n.5 ("There is nothing in the
act . . . that indicates a general Congressional or administrative
position
toward the exclusion of prejudgment interest."); Kovacs, 100 T.C. at 132
("[W]e perceive no relief that [petitioners who receive a lump sum award]
can derive from the Periodic Payment Settlement Act of 1982.").

                                14



interest is an element of compensatory damages in actions
for personal injuries, awarded to compensate the plaintiff
for the time value of the award eventually obtained against
the tortfeasor"). Nonetheless, the Court in Brabson found
prejudgment interest to be taxable for two reasons.

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 Colo.
Rev. Stat. S 13-21-101(1) to that effect in 1979, the Tenth
Circuit concluded that Congress could not have intended
prejudgment interest to be included among those damages
exempt from taxation in the predecessor provisions to
today's S 104(a)(2). Id. This conclusion was well-founded, for
it is beyond cavil that Congress in the early twentieth
century was cognizant of the common law prohibition on
the award of prejudgment interest in personal injury
actions. See Monessen S.W. Ry. Co. v. Morgan, 486 U.S.
330, 337 (1988) (discussing whether Congress provided for
prejudgment interest in the Federal Employers' Liability Act
of 1908 ("FELA") and noting that Congress was aware that
"the common law did not allow prejudgment interest in
suits for personal injury or wrongful death. . . . This was
the rule in the federal courts."). The Brabson court thus
discounted the characterizations of the Colorado Supreme
Court that prejudgment interest was an element of
compensatory damages. It instead recognized Congress
provided no indication that prejudgment interest should be
exempted from taxation as received on account of a
personal injury. Brabson, 73 F.3d at 1046."While the
Colorado statute may contemplate a different
understanding of the concept of damages, we believe it
contrary to the concept of damages for personal injuries as
understood in the Revenue Act of 1918 and maintained
ever since." Id.

Secondly, the Tenth Circuit in Brabson recognized that
delay damages did not fit easily within the human capital
rationale that underlies S 104(a)(2). "[C]ompensation for the
lost time value of money is caused by the delay in attaining
judgment. Time becomes the relevant factor, not the injury

                               15



itself -- the longer the procedural delay, the higher the
amount." Brabson, 73 F.3d at 1047. The Brabson court
noted that the quantity of prejudgment interest turns not
on the personal injury itself, but instead on the time value
of money. It concluded that the time value of money is not
received "on account of " a tort-like injury and therefore
cannot satisfy the second showing required by Schleier, 515
U.S. at 337. "In short, though [prejudgment interest] is
related to the injury, both in terms of existence and
computation, the award of prejudgment interest is not
linked to the injury in the same direct way as traditional
tort remedies." Brabson, 73 F.3d at 1047.

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
under Schleier -- that "the damages were received on
account of personal injuries or sickness." Schleier, 515 U.S.
at 337. Applying the two-part test of Schleier , Rozpad
concluded, much like Brabson, "that prejudgment interest
is not `damages' received `on account of ' a personal injury,
and is, therefore, taxable." Rozpad, 154 F.3d at 6. The
Court thought it important that, under Rhode Island law,
"interest is separate and distinct from damages, and is
awarded mainly to compensate for a delay in payment." Id.
This delay in payment is not caused by the personal injury,
but rather "the injury causes damages, thus creating the
fund on which interest for delay in payment is owed." Id.
The First Circuit then reiterated Brabson's conclusion that
Congress could not have intended that prejudgment
interest be included in the predecessor to S 104(a)(2),

                               16



because prejudgment interest was unavailable at the
common law in personal injury torts. Id. at 7.

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
_________________________________________________________________
11. Indeed, in Laudenberger, the Pennsylvania Supreme Court described
the Michigan prejudgment interest statute, Mich. Comp. Laws
S 600.6013, discussed in Kovacs, the Colorado prejudgment interest
statute, Colo. Rev. Stat. Ann. S 13-21-101, discussed in Brabson, and
the Rhode Island prejudgment interest statute, R.I. Gen. Laws S 9-21-10,
discussed in Rozpad, among others, as "similar pre-trial interest
provisions." Laudenberger, 436 A.2d at 153. The only distinction drawn
between these statutes and Rule 238 in Laudenberger was their method
of enactment, the former three by legislative enactment and the latter by
the promulgation of court rules. Id.

                               17



intend S 104(a)(2) to exempt prejudgment interest when no
Pennsylvania plaintiff recovering for personal injury would
have been awarded such interest at common law.

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

                               18



       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 S 104(a)(2) and its predecessors,
intended the exclusion of prejudgment interest, such as
Rule 238 delay damages, from income.

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 S 104(a)(2) does not accomplish this purpose perfectly
because it excludes from taxation both the traditionally
untaxed "damages that aim to substitute for a victim's
physical or personal well-being" and the traditionally taxed
"damages that substitute . . . for lost wages," nevertheless
the Court emphasized that the human capital rationale was
the "original mooring[ ]" of S 104(a)(2). O'Gilvie, 519 U.S. at
86. That original mooring dictates that "there is no strong
reason for trying to interpret the statute's language to reach
beyond those damages that, making up for a loss, seek to
make a victim whole, or speaking very loosely, `return the
victim's personal or financial capital.' " Id.

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
Laudenberger, the essence of Rule 238 is to"provide[ ]

                                19



compensation to a plaintiff for delay in receiving the
monetary damages owing as a result of a defendant's tort.
This serves to indemnify the plaintiff for the money he
would have earned on his award if he had promptly
received it." 436 A.2d at 154. It cannot be rationally
contended that the "money he would have earned on his
award" is anything but interest. Interest is"the
compensation fixed by agreement or allowed by law for the
use or detention of money. . ." Black's Law Dictionary 816
(7th ed. 1999).

As noted in Kovacs, since the 1933 case of Riddle v.
Commissioner, 27 B.T.A. 1339, 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 26 U.S.C.
S 61(a)(4).

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

                                20
indignity, pain, embarrassment and humiliation of his
bodily injuries caused by the delay in receiving just
compensation for those injuries . . . ." Taxpayers' Opening
Br. at 26. The defendant's liability for this compensation is
described as a "procedural fault." Costa , 626 A.2d at 570.

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 theS 104(a)(2)
exemption and stated that "one of the hallmarks of
traditional tort liability is the availability of a broad range
of damages to compensate the plaintiff `fairly for injuries
caused by the violation of his legal rights.' " Id. at 234-35
(citation omitted). Rule 238 delay damages do not fit within
this injury compensation rubric. Instead, they only
compensate for the additional economic harm -- as
opposed to the injury itself -- caused by the deprivation
over a period of time of the underlying remedy. See
Laudenberger, 436 A.2d at 154.

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
_________________________________________________________________

12. While we acknowledge that the underlying recovery of damages for
personal injury is based in tort, we are required under S 104(a)(2) to
parse the separate elements of the damages award to ensure that each
fulfills the statute's criteria. See Schleier , 515 U.S. at 330 ("each
element
of the settlement is recoverable not simply because the taxpayer received
a tort settlement, but rather because each element of the settlement
satisfies the requirement set forth in S 104(a)(2)").

                               21



damages permitted by the Age Discrimination in
Employment Act of 1967 (ADEA), "that if Congress had
intended the ADEA's liquidated damages to compensate
plaintiffs for personal injuries, those damages might well
come within S 104(a)(2)'s exclusion." Schleier, 515 U.S. at
331. From this Taxpayers argue that Rule 238 is a
liquidated damages scheme, intended to compensate
plaintiffs for personal injuries, and that such damages are
therefore exempt from taxation under S 104(a)(2). We reject
this argument, however, for the same reason that the
Supreme Court rejected the argument in Schleier - neither
delay damages nor liquidated damages in the ADEA
compensate for a `personal,' as opposed to `economic,'
harm. The Court noted in both Schleier13 and Burke that
"compensation" exempt from taxation underS 104(a)(2)
must be for "traditional harms associated with personal
injury, such as pain and suffering, emotional distress,
harm to reputation, or other consequential damages."
Burke, 504 U.S. at 239; Schleier, 515 U.S. at 335-36 (citing
Burke). While we recognize that the deprivation of a
monetary remedy for an underlying personal injury may, of
itself, cause additional emotional distress and other
damages, Rule 238 provides only for compensation for the
"economic" harm caused by the defendant's refusal to settle
reasonably and expediently a meritorious claim and not for
the potential harm on which Taxpayers assert we should
exempt all delay damages. Because compensation for
"economic" harm in the form of interest is usually taxable
and thus is "not a substitute for any normally untaxed
personal (or financial) quality, good, or `asset,' " we see no
reason why either the statutory text of S 104(a)(2) or its
rationale would support exempting delay damages from
income. O'Gilvie, 519 U.S. at 86.

Nor is our conclusion that delay damages are not
included within the scope of S 104(a)(2) swayed by the
Taxpayers' argument that the 1996 amendments to that
statute alter our analysis. In 1996, Congress passed the
Small Business Job Protection Act, which expressly made
_________________________________________________________________

13. Indeed, the Schleier Court noted the presence of liquidated damages
in the ADEA was not "sufficient to bring it within Burke's conception of
a `tort type righ[t].' " Schleier , 515 U.S. at 335.

                               22



punitive damages taxable and limited the exemption to
"physical" personal injuries and "physical" sickness. See
110 Stat. 1755, 1838-39, Pub. L. 104-188, S 1605 (August
20, 1996). Because the Taxpayers' settlement was agreed
upon before the effective date of the amendment, it is
undisputed that the additions to S 104(a)(2) do not apply to
this case. Nonetheless, the Taxpayers argue that language
from the House Report on the amendments to S 104(a)(2),
when read in conjunction with the Supreme Court's
decision in Schleier, demonstrates a congressional intent
that courts construe the personal injury exemption broadly
to include delay damages.

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 S 104(a)(2) to include delay damages.

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 S 104(a)(2). Id. Thus, the legislative history
is not clearly in support of the Taxpayers' suggested
interpretation of the statute. Two, the Supreme Court's
opinion in O'Gilvie forecloses the possibility that all
damages that flow from a personal injury are exempt from
taxation. 519 U.S. at 82. In O'Gilvie, decided in 1998 but
interpreting the same pre-amendment version of S 104(a)(2)
with which we are concerned, the Court held that the"on
account of " language of the statute cannot be interpreted
to require only a "but-for" connection between the
underlying personal injury and the award at issue. Id. It
cautioned that such a broad scope "would thereby bring
virtually all personal injury lawsuit damages within the

                               23



scope of the provision, since: `but for the personal injury,
there would be no lawsuit, and but for the lawsuit, there
would be no damages.' " Id. Thus, the Court rejected a
formulation of "on account of " that is substantially
identical to the language used in the House Report -that
"all damages . . . that flow therefrom" should be exempt.
Even if we were to assume that this lone statement from
the legislative history of the 1996 amendment applied to
prior versions of the statute, the Supreme Court has
rejected such an expansive interpretation of S 104(a)(2).

Having considered both the language of S 104(a)(2) and
its rationale, we are not persuaded that Rule 238 delay
damages can be meaningfully distinguished from
prejudgment interest in general simply because they are
only available when the defendant has delayed the trial or
not made an adequate settlement offer. For this reason, we
affirm the District Court's ruling that the Taxpayers'
recovery of delay damages should have been taxed.

IV. ALLOCATING DELAY D AMAGES 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
_________________________________________________________________

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 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
_________________________________________________________________

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. 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
_________________________________________________________________

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 were"without 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, stating"I 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, non-
taxable 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

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