Francisco v. U.S.

• Decision Date: 05 February 2001
• Docket Number: No. 00-1802,00-1802
• Citation: 267 F.3d 303
• Parties: (3rd Cir. 2001) CHARLES FRANCISCO; CECILIA FRANCISCO, APPELLANTS v. UNITED STATES OF AMERICA Argued:
• Court: U.S. Court of Appeals — Third Circuit

Page 303

267 F.3d 303 (3rd Cir. 2001)

CHARLES FRANCISCO; CECILIA FRANCISCO, APPELLANTS v. UNITED STATES OF AMERICA

No. 00-1802

UNITED STATES COURT OF APPEALS FOR THE THIRD CIRCUIT

Argued: February 5, 2001

Filed October 1, 2001

On Appeal from the United States District Court for the Eastern District of Pennsylvania District Judge: Honorable Anita B. Brody (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

Before: Becker, Chief Judge, Ambro and Stapleton, Circuit Judges

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.

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 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 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.

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 of S 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 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 (1...