Bagley v. C.I.R.

• Decision Date: 01 October 1997
• Docket Number: No. 96-1768,96-1768
• Parties: -5739, 97-2 USTC P 50,586 Hughes A. BAGLEY and Marilyn B. Bagley, Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Appellee.
• Court: U.S. Court of Appeals — Eighth Circuit

Page 393

121 F.3d 393

80 A.F.T.R.2d 97-5739, 97-2 USTC P 50,586

Hughes A. BAGLEY and Marilyn B. Bagley, Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Appellee.

No. 96-1768.

United States Court of Appeals Eighth Circuit.

Submitted June 9, 1997.

Decided Aug. 6, 1997.

Rehearing and Suggestion for Rehearing En Banc Denied Oct. 1, 1997.

Mark Arth, Sarasota, FL, argued, for appellants.

Edward T. Perelmuter, Department of Justice, Washington, DC, argued (Bruce R. Ellison, on the brief), for appellee.

Before RICHARD S. ARNOLD, Chief Judge, HENLEY, Senior Circuit Judge, and WOLLMAN, Circuit Judge.

RICHARD S. ARNOLD, Chief Judge.

In August 1987, Hughes Bagley settled an eight-year-old lawsuit against Iowa Beef Processors Inc. ("IBP"), for $1.5 million. In their tax return for that year, Mr. Bagley and his wife, Marilyn Bagley, excluded the entire settlement amount from their taxable income. The Commissioner determined that $1,305,000 of the $1.5 million was not excludable and asserted a deficiency in the Bagleys' 1987 income tax, a determination which the Bagleys contested in the Tax Court. The Tax Court ¹ held that $500,000 of the settlement was not excludable, Bagley v. Commissioner, 105 T.C. 396, 1995 WL 730447 (1995), and the Bagleys appealed. We affirm.

I.

This case addresses the tax consequences of a settlement that followed our decision in In re IBP Confidential Business Documents Litigation (Bagley v. Iowa Beef Processors, Inc.), 797 F.2d 632 (8th Cir.1986) (en banc), reh'g denied, 800 F.2d 787 (1986) (en banc), cert. denied, 479 U.S. 1088, 107 S.Ct. 1293, 1294, 94 L.Ed.2d 150 (1987). The facts of the case are recounted in that opinion, and there is no need to detail them here. What is important for purposes of this appeal is that a jury in 1982 found IBP liable to Bagley on four separate claims and awarded compensatory damages in the amount of $1.5 million and punitive damages in the amount of $7.25 million. The breakdown was as follows:

                   Claim                       Compensatory   Punitive
                   Tortious interference with   $  150,000   $  500,000
                       present employment
                   Tortious interference with   $  100,000   $  250,000
                       future employment
                   Libel                        $1,000,000   $5,000,000
                   Invasion of Privacy          $  250,000   $1,500,000
                                               ------------  ----------
                   Total                        $1,500,000   $7,250,000
                

In response to IBP's subsequent motion for judgment notwithstanding the verdict, the District Court dismissed the invasion-of-privacy claim, finding that the jury's award was duplicative of the libel award, but upheld the remaining three claims. On appeal, this Court reversed the libel judgment and remanded the libel claim for a new trial because the District Court had erroneously instructed the jury that defendant IBP bore the burden of proof on a key issue. This Court affirmed the judgment on the tortious interference-with-present-employment claim. In addition, we upheld the tortious interference-with-future-employment judgment with respect to liability but vacated it with respect to damages. We then remanded with instructions that if Bagley prevailed on his libel claim on retrial, the District Court should then determine the extent to which the tortious-interference-with-future-employment damages were duplicative of the libel award. After our decision, in denying as premature Bagley's motion to reinstate the invasion-of-privacy award, the District Court stated that if Bagley lost his libel claim at trial or elected not to pursue it further, the Court would be inclined to reinstate the awards for invasion of privacy and tortious interference with future employment.

Less than two months before a new trial on the libel claim was scheduled to begin, the parties met for a settlement conference. During the conference, IBP's lawyer told Bagley's lawyer that IBP would not agree to pay punitive damages. After two weeks of negotiations, the parties agreed to settle the case for $1.5 million. The settlement agreement stated that the award was paid "as damages for personal injuries including alleged damages for invasion of privacy, injury to personal reputation including defamation, emotional distress and pain and suffering." IBP also agreed to dismiss a pending cause of action that it had filed ten years earlier against Bagley, and Bagley agreed to return to IBP business documents that he had in his possession. The parties also agreed to use their best efforts to keep the terms of the settlement confidential. Bagley released all his claims against IBP, including, necessarily, any claim for punitive damages.

On their 1987 tax return, the Bagleys excluded the entire amount of the settlement from their taxable income. The Commissioner maintained that $1,305,000 of the settlement agreement was a taxable award of punitive damages and asserted a deficiency in the Bagleys' 1987 income tax. The Bagleys filed a petition in the Tax Court challenging the Commissioner's determination. They first argued that punitive damages are not taxable, a position with which the Tax Court disagreed, and one that is no longer tenable given the Supreme Court's recent decision in O'Gilvie v. United States, 519 U.S. 79, 117 S.Ct. 452, 136 L.Ed.2d 454 (1996). In O'Gilvie, the Court held that the Internal Revenue Code's exclusion for damages "received on account of personal injuries" did not include punitive damages and, therefore, that punitive-damage awards are taxable income. ² The Bagleys have abandoned their challenge to this part of the Tax Court's holding on appeal.

Second, the Bagleys argued that none of the $1.5 million settlement represented the payment of punitive damages. Accordingly, they argued, the entire amount was properly excluded as compensatory damages received on account of personal injuries under 26 U.S.C. § 104(a)(2). While the Tax Court disagreed with the Commissioner's contention that $1,305,000 of the settlement was taxable, ³ it also disagreed with the Bagleys' contention that none of it was. Instead, the Tax Court reasoned that "it is reasonable to assume that IBP would have paid in settlement to [Bagley] the entire $1 million that the jury had found he was due as compensatory damages [on the libel claim]. However, ... the remaining $500,000 was in settlement of possible punitive damages [Bagley] might have recovered." 105 T.C. at 410. The Court thus held that "of the $1.5 million settlement amount, $1 million was for compensatory damages and $500,000 was for punitive damages." Ibid. This appeal followed.

II.

When assessing the tax implications of a settlement agreement, courts should neither engage in speculation nor blind themselves to a settlement's realities. See Delaney v. Commissioner, 99 F.3d 20, 23-24 (1st Cir.1996) (court must look beyond language of settlement to determine " 'in lieu of what' " were damages paid) (citation omitted) (emphasis omitted). The reality when settlement negotiations began was that even if IBP had won Bagley's pending libel suit, it almost certainly would have had to pay $250,000 in punitive damages and would also have faced a significant risk of having to pay an additional $1,500,000 in punitive damages. ⁴ If IBP had lost the libel suit, its liability was uncertain, but a jury had already awarded Bagley $5,000,000 in punitive damages on the claim. ⁵ Therefore, IBP would in all likelihood have had to pay a sizable punitive-damage award whether it won or lost the libel suit. The Bagleys' argument that none of the settlement is taxable requires us to believe that this potential liability did not affect the size of the settlement at all, and thus, that IBP paid nothing to Bagley to secure a release from this sizable exposure.

In support of this unlikely contention, the Bagleys point to the absence of any reference to punitive damages in the settlement agreement and the statement of IBP's lawyer at the commencement of settlement negotiations that IBP refused to pay punitive damages. Both pieces of evidence demonstrate at best that IBP did not want to show an allocation to punitive damages in the settlement agreement. But proof of a defendant's desire or intent not to show an award of punitive damages does not establish that the defendant did not pay something to avoid punitive damages, where there is solid evidence that the prospect of punitive-damages liability necessarily increased the amount that the defendant paid in settlement.

The Bagleys argue correctly that the language of a negotiated settlement agreement that allocates nothing to punitive damages should not lightly be disregarded. Initially, however, we note that while the agreement in this case does not expressly allocate anything to punitive damages, it also does not explicitly say that punitive damages are not part of the settlement. ⁶ More importantly, the language of a settlement agreement cannot always be dispositive. It will almost never be to a defendant's advantage to allocate part of a lump-sum settlement to punitive damages, and it will often be disadvantageous. Often, insurance policies will not cover such awards, and punitive-damage awards result in worse publicity than compensatory awards. Most p...