Personal Injury Settlements After the Jury Or Judge Or Opposing Side Has Spoken
An article of faith among personal injury lawyers is that all damages should not be taxable. Legislative and judicial developments have sorely tested their faith. This article addresses one aspect of this continuing saga -- the difficulties encountered once a jury or judge has spoken as to the underlying claims and a spin on that -- the difficulties encountered after the paying party speaks on the allocation of the claim..
This article is inspired by two recent decisions -- Rozpad v. Commissioner, ___ F.3d ___ (1st Cir. 8/25/98), reprinted at 98 TNT 166-4 (8/27/98) and Srivastava v. Commissioner, T.C. Memo. 1998-362, reprinted at 98 TNT 194-6 (10/7/98).
In Rozpad (a combined decision involving two sets of similarly situated taxpayers), the taxpayers obtained jury verdicts for personal injury damages. The resulting judgment included damages excludable under Section 104 and prejudgment interest as allowed by local law. After judgment, the taxpayers settled their claims. The settlement documents provided lump-sums, with no allocations between the damages and the prejudgment interest. The taxpayers did not report the settlement amounts on the ground that the undifferentiated settlement meant that the entire settlement was excludable under Section 104. The IRS asserted a tax on the prejudgment interest component inherent in the settlement. The IRS determined the prejudgment interest component by a simple ratio -- the prejudgment interest in the original awards divided by the total original awards. The Tax Court sustained the IRS. The Court of Appeals affirmed.
In Srivastava, the taxpayer sued for defamation and various related claims, seeking actual damages for Section 104 excludable claims in excess of $8,500,000 and punitive damages in excess of $2,000,000, with pre-judgment and post-judgment interest. The jury held for the taxpayer, assessing actual damages at $11,500,000 and $17,500,000 of punitive damages. The trial court found that a portion of the actual damages had accrued before judgment, entitling the taxpayer to pre-judgment interest, which it calculated to be $2,597,201. The trial court also awarded post-judgment interest until collection. During the ensuing appeals process, the case settled for $8,500,000, as a lump sum not allocated to any particular claim. The taxpayer did not report the recovery, apparently on the basis that it all qualified as actual personal injury damages under Section 104. The IRS objected, urging that the settlement should be allocated on the ratios of the trial court awards (both jury and judge awards), so that a significant portion of the amount was allocated to interest and to punitive damages, both of which, the IRS urged, were taxable. The Tax Court agreed with the IRS that the entire settlement was not actual personal injury damages, but rather included components for interest and punitive damages. I shall discuss below how it made the allocation, because it was not simply the application of the ratios and was, a rather sophisticated economic model of the settlement dynamics from the paying parties' (defendant's and insurers') perspectives.
Rozpad and Srivastava set the stage for some interesting points.
The Nature of Prejudgment Interest
Although nothing is certain in the tax law, the courts have a firm basis in logic and in precedent for concluding that prejudgment interest is not a recovery on account of personal injury but is rather a recovery for the forbearance of money. See Wood, Interest Characterization in Settlement Agreements, 74 Tax notes 1337 (3/10/97) (discussing cases). I doubt that this notion offends anyone except the most die hard plaintiff's lawyers and their clients, and then not solely on principle. Of course, well-informed taxpayers will not forego a claim for prejudgment interest just to avoid being taxed on the interest. But, as in Rozpad and other cases, latter-day legal alchemists will try to make the economic recovery look like something else that is not taxable. The holy grail could be reached in Rozpad, the taxpayers and their representatives hoped, by making the settlement a lump-sum settlement that appeared on its face not to have any component of prejudgment interest.
The alchemy might work where the right to recover is uncertain, for then the taxpayer could at least argue that the allocation of no part of the settlement to prejudgment interest was based on state law. More importantly, even in a state clearly requiring prejudgment interest, the alchemy might work if the settlement is reached prior to the jury or judge making findings on the value of the components. The Rozpad court suggested as much in the following analysis (emphasis in original):
The case law, though sparse, seems to draw a well-conceived line that refutes the petitioners' challenge. 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. After all, a settlement of a claim for personal injuries almost inevitably will take into account a multitude of factors (e.g., the nature of the injuries, the measure of damages, attendant pain, the economic loss, the prognosis for the future, the strength or weakness of the victim's case on liability, the immediacy of the victim's need for funds, the depth of the tortfeasor's pocket, the presence or absence of legal representation, the costs of trial, the extent of anticipated delays, and the availability vel non of punitive damages and/or prejudgment interest), and the parties typically will not assign independent monetary values to each of these factors. To complicate matters further, some of these factors (e.g., the costs of trial) would not themselves bear prejudgment interest. Thus, the absence of an allocation renders it too speculative for a court, in hindsight, to assign independent weight to each relevant factor and isolate a reliable figure representing prejudgment interest.
On the other hand, 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. [citations and footnote omitted] In this hermeneutic, the parties have settled a claim for a liquidated amount -- and 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. [citations omitted] That assumption has particular force where, as here, the appeal period had not run and the settlement amount exceeded the amount of the damages recovered. [footnote omitted] This concatenation of circumstances leaves no doubt but that the settlement includes some prejudgment interest.
In Rozpad, the issue was to determine the amount of the pre-judgment interest in the otherwise lump-sum settlements. By using the ratios determined in the jury verdict, the Tax Court and the Court of Appeals had a handy objectively determinable methodology for making the allocation. The Court of Appeals said (emphasis added):
Consistent with the authorities we have cited, we hold that when an amount has been received in settlement of a claim after the claim has been reduced to judgment, the judgment, albeit not final, nonetheless furnishes an adequate guideline for allocation by the Commissioner to the extent that it is composed of both compensatory damages and prejudgment interest.
This "adequate guideline" exists only where there has been a decision as to damages, so that the calculation of interest is perfunctory. There is, of course, another way to get to the underlying interest even where the guideline is not present. If the state law is certain that the taxpayer is entitled to prejudgment interest, can it not be argued that every settlement -- even one reached before trial where the guideline is not present -- economically contains something for the right to prejudgment interest? In any undifferentiated settlement the IRS could seek to differentiate the principal component and the interest component using tools already recognized both in the real world and the unreal world of the tax code -- discount the settlement to reflect the prejudgment interest from the date the damages accrued to the date of the settlement. That is not a difficult calculation, nor is it inconsistent with economic reality in differentiating principal from interest. If the line of cases leading to Rozpad are correct that the interest in a settlement is not entitled to favorable Section 104 treatment, then one could argue so should it be for undifferentiated settlements where the law is clear that the taxpayer is entitled to prejudgment interest, with the discount factor supplying the objective determinant. After all, we learned in high school that things equal to the same thing are equal to each other.
Nevertheless, that is not what the Court said in the quote above. Pre-judgment settlements are based on a host of loosey-goosey factors other than the mathematical certainty that appears to inhere in discounting. For this reason, I suspect that the Courts will continue to adhere to the proposition that undifferentiated pretrial settlements for recoveries otherwise excludable under Section 104 should be excludable. Wood, Interest Characterization in Settlement Agreements,supra; citing Raby, When Interest Is Not Interest, Tax Notes, Oct. 10, 1994, p. 229.This places a premium on pretrial settlements, which may have the broader societal value of further encouraging pretrial settlements.
If there is a jury verdict in hand, the incentive will be to settle before judgment is entered, but the IRS may make the simple interest calculation that would have been reflected in the judgment. The real incentive to settle will come before the jury verdict. In the give and take of negotiations between well-informed plaintiffs and defendants, there should be an opportunity -- preferably understood and unspoken -- to split the economic benefit of the tax savings on a Win-win basis. A lump-sum settlement should do nicely.
Another alternative is the structured settlement. Section 104(a)(2) allows periodic payments to qualify. The dollar amount of the periodic payments should reflect interest, both pre-settlement interest in those states where the taxpayer is entitled to pre-judgment interest and post-settlement interest during the payout period. Section 104(a) bulletproofs the tax consequences of the periodic payments. There is opportunity here.
Srivastava involved interest and punitive damages. Historically, courts had considered punitive damages to be excluded under Section 104(a)(2). But, cracks in the dam occurred in the late 1980's and by 1995 the Fifth Circuit (as had some other courts) reached the conclusion that punitive damages were not personal injury damages and therefore not excludable. Hence, at trial in Srivastava, the taxpayer was faced with the double burden of saying that no portion of the lump-sum settlement represented a recovery for his punitive damage or interest claims, after the jury and judge, respectively, had held that he did have a right to recover on those claims. However, critically, instead of making a simple allocation based upon the allocations in the judgment, the Tax Court at the IRS's urging on trial made a more sophisticated allocation that it viewed as consistent with the real deal.
In order to understand the Court's methodology (actually the IRS's trial methodology approved the Court), we must provide a few more facts. The defendant in the tort suit had "tiered" insurance -- multiple insurers at various levels of liability. Thus, two insurers (the first tranche insurers) covered to $2,000,000, another (the second tranche insurer) from $2,000,000 to $7,000,000, another (the third tranche insurer from $7,000,000 to $12,000,000, another (the fourth tranche insurer) from $12,000,000 to $22,000,000, and another insurer (the fifth tranche insurer) over $22,000,000. Post-judgment and during the settlement negotiations, it came out that two of the insurance companies -- the second and third tranche insurers covering the range from $2,000,000 to $12,000,000 were insolvent. The parties then negotiated the settlement of $8,500,000, with the costs being shared between the defendant and the insurance companies as follows: (1) in satisfaction of the first $7,000,000 of the judgment, the first tranche insurers agreed to pay $2,100,000 (it is not clear why they agreed to pay more than their limits) and the defendant agreed to $1,000,000. (2) in satisfaction of the judgment between $7,000,000 and $12,000,000 and to the extent necessary to settle post-judgment interest on the first $22,000,000, the defendant agreed to pay $2,400,000; and (3) the fourth and fifth tranche insurers agreed to pay $3,000,000. The Court found that, in reaching the settlement, the payors did not consider whether they were paying for actual or punitive damages and did not discuss any allocation of the amounts that they were paying.
As noted above, in its initial determinations (in the notice of deficiency), the IRS had made the allocation as in Rozpad on the basis of the determinations at the trial level. The taxpayer sought to allocate all to actual damages, on the theory that he had plead $8,500,000 of actual damages and, he felt, proved that amount at trial, so that no part of the recovery was for taxable interest and punitive damages. At trial, the IRS broached a different allocation, based on its view of the "real deal" reflected in the actual payments from the defendant and the various insurers. Basically, the logic of that allocation rested on the notion that, if only $8,500,000 were the actual damages being paid, the the fourth and fifth tranche insurers should not have paid anything. The fact that they paid anything suggested that they were paying to settle amounts in excess of the actual damages found by the jury ($11,500,000) and those excess amounts were taxable amounts. The Court then described the methodology as follows: "under this alternative method, it is presumed that actual damages would be paid before prejudgment interest, postjudgment interest, or punitive damages, and that prejudgment interest would be paid before punitive damages."
The methodology then was:
(1) The $3,100,000 paid by the first tranche insurer and the defendant (who would have otherwise been covered by the second tranche insurer then insolvent) settled the first $7,000,000, because that was the risk tranches that they were liable. Since it was allocated first to actual damages (assessed by the jury at $11,500,000), that amount was treated as actual damages.
(2) The amount of $2,400,000 then paid by the defendant to settle the liability between $7,000,000 and $12,000,000 (insurer also insolvent) and interest was allocated in the ratios of the gross amounts thus settled (i.e., $4,500,000 of actual damages, prejudgment interest of $500,000 and post judgment interest of $1,826,301).
(3) The amount of $3,000,000 paid by the fourth and fifth trance insurers is allocated entirely to prejudgment interest and punitive damages.
Based on this methodology, $4,682,116 (about 55% of the settlement proceeds) was for actual damages excludable under Section 104 and $3,817,884 (about 45%) was for interest and punitive damages, both of which are not excludable under Section 104. This new methodology, more sophisticated than the IRS's first shot in the notice of deficiency, substantially worked in the taxpayer's favor. As we calculate the initial methodology, only $2,924,589 (about 34% of the settlement proceeds) would have been allocated to actual damages excludable under Section 104, and the balance of $5,575,411 (about 66%) would have been allocable to taxable damages. Accordingly, the IRS did the taxpayer a favor for developing this alternative, more sophisticated (but still objective) methodology, thus saving him at least $500,000 in taxes plus deficiency interest.
In its quest for certainty and objective determinants, the Court accepted the paying parties' model of the settlement. A settlement, however, reflects both sides' determinations and negotiations -- not just one side's. That is like applying the willing buyer, willing seller test only from the willing buyer's standpoint. Accordingly, I have serious concern about using the paying side's unilateral allocations as the sole determinant for allocating the taxpayer's settlement proceeds. Merely because the paying parties sliced and diced their payment contributions in a certain way that reflected their internal negotiations does not mean that that reflects the real deal from the perspective of the other key party -- the party receiving the payments in settlement of his claims. Nevertheless, this "objective determinant" was far more favorable to the taxpayer than the alternative objective determinant -- the judge and jury's original determinations. The methodology seems designed to be more favorable to the taxpayer in other cases, for allocations go first to the actual excludable damages and the lower level tranches will almost certainly settle for higher percentages of outstanding exposure than the higher level tranches.
The Quest for External Certainty
The Roszpad analysis and the Srivastava refinement suggest that the IRS and the Courts will stretch for some objective certainty to the quest for determining the "real deal." In Rozpad, the objective determinant was the jury verdict and assessment of prejudgment interest prior to the settlement. Rozpad cited other cases in which courts have looked to similar objective determinants to determine which part of a settlement is excludable and which not. Srivastava took the quest one objective level deeper into the facts, but still with a preference to some objective determinant.
Robinson v. Commissioner, 70 F.3d 34, 38 (5th Cir. 1995), cert. denied, 117 S. Ct. 83 (1996), a case I handled at trial, is another case in point. In Robinson, the taxpayers, business creditors of a bank, sued the bank under various lender liability theories. The damage claims included personal injury claims, lost business profits claims and punitive damages claims. After trial, the jury rendered its verdict for $59,000,000 (app.), and allocated that amount among the three categories in roughly the following ratios: lost profits: 10%, personal injury 5% and punitive damages 85%. Before judgment was entered, the parties settled the case for a cash payment of $10,000,000, allocating 95% to the personal injury damages, and an additional consideration of relief from indebtedness to the bank, that is not here relevant. Judgment was entered consistent with the settlement. The IRS then contested the 95% allocation. The Tax Court repaired to the objective determinant -- the ratios determined by the jury verdict, with a slight twist. The Court believed that the "water" in the jury verdict prompting the settlement for a greatly reduced figure was in the punitive damages and not in the lost profits or personal injury. Accordingly, it allocated the settlement first to the amount of the jury awards for the lost profits and personal injury and then allocated the balance of the settlement to punitive damages. On this allocation, consistent with the Tax Court's precedent at the time, the Tax Court excluded the personal injury damages and the punitive damages relating to the personal injury damages. The Court of Appeals affirmed, but consistent with the then trend in the law held that punitive damages on personal injury damages were not excludable.
The Tax Court took the easy route by basing the tax conclusion on the jury verdict, treating the jury's determinations as to the substantive claims (lost profits and personal injury) as being fully creditable and sustainable on appeal. The approach is simplistic, and wrong, as a simple example will illustrate. Suppose the taxpayer sues for one claim clearly excludable ("Excludable Claim") and for another that is clearly not excludable ("Includable Claim"). In his pleadings, the taxpayer asserts aggregate damages of $2,000,000, equally split between the Excludable Claim and the Includable Claim. In assessing his client's case, the lawyer feels more comfortable about the Excludable Claim, but throws in the Includable Claim for negotiating purposes and to permit the jury to split the pie at trial. At trial, the taxpayer introduces sufficient evidence on damages in both respects to the get to the jury. The jury finds the defendant liable on both Claims and awards the requested damages. The parties then settle for $1,000,000 and allocate 90% to the Excludable Claims.
If that is all we know about the case, then it might well be appropriate to let the jury verdict determine the tax allocation. But, there is an implicit assumption in using that determinant -- i.e., that the claims are indeed equally valuable in terms of the settlement. That may not be a good assumption and, indeed, I suspect that it is the rare case that it is a good assumption.
Let's add some key facts to illustrate. Let's assume that, properly valued, the Excludable Claim is by far the more defensible on appeal and that there are major problems on appeal with the Includable Claim. Attorneys familiar with all the facts and law (including the appellate courts for the appeal and the trends in the state law on the issues) would assess the likelihood of sustaining the Excludable Claim at 90% and of sustaining the Includable Claim at 10%. Adding these facts, therefore, it would be fair to conclude that, for settlement, the Excludable Claim would be "Worth" $900,000 and the Includable Claim would be worth $100,000 and that reasonable parties could reach a settlement in accord with that assessment. Why, under these facts, should the objective jury verdict prime the parties' good faith assessment of the claims? Stated alternatively, why does the jury verdict determine the relative values of the claims for settlement purposes?
The search for some objective determinant is only human. A handy proxy to preserve the IRS's and courts' limited resources must be a beguiling alternative to a tough inquiry. But, all we are talking about here are valuation issues, and such easy proxies are mere anodynes for the pain of valuing. (This is, of course, a spin on Judge Hand's famous quote that substance and form labels are "Anodynes for the pain of reasoning." Commissioner v. Sansome, 60 F.2d 931, 933 (2d Cir.), cert. denied, 287 U.S. 667 (1932).) The settlement ought to be allocated according to the real value of the underlying claims. I doubt that there are many, if any, cases involving multiple claims where, after trial and for settlement purposes, either party actually assesses the underlying claims in the same ratios that the jury did.
In Robinson, as noted above, the trial judge allocated 100% to the lost profits and the personal injury claims based on the jury verdict. But, as we attempted to prove and the court apparently viewed as irrelevant, those two claims were not equal in merit. The lost profits claim had substantial problems under the proof at trial and under Texas law, whereas the personal injury claim, with some significant level of attendant sustainable punitive damages, appeared a lead pipe cinch to prevail on appeal. The Court's residual formula allocated all uncertainty in the issues to punitive damages, whereas in truth considerable uncertainty inhered in the lost profits portion of the verdict and the punitive damages attributable thereto. This would have made a major difference in the Tax Court decision which allocated the residual punitive damages between excludable and non-excludable recoveries, but would not have made a difference on appeal if the amounts resulting from lowering the lost profits allocation all went to punitive damages which the Court of Appeals held were all taxable.
We submit courts should not give undue deference to jury verdicts. If, in the rare case, there is absolutely nothing else upon which to determine the relative values of the claims for settlement purposes, I suppose the jury verdict will do. But, courts should not shy away from the tough work of determining relative values so that the tax consequences do really depend upon the real deal. Again, all we are talking about are valuation issues, issues that courts resolve every day regardless of the difficulties and complexities involved. Jury verdicts (or judicial decisions in judge tried cases) may be a starting point in that analysis, but they should not be the ending point.
Planning
I believe that in cases presenting the right facts courts might be willing to go to the substance despite a contrary jury verdict. Robinson may or may not have been the case. But in order to represent their clients, personal injury lawyers should build their case at the settlement table, just as they build any case with the thought that they may have to convince a judge someday that their allocations state the real deal. The foregoing discussion suggests that the parties consider the following:
1. In any allocation, as in other areas of our personal and tax lives, do not be a pig. Anchor the allocation to something that is defensible.
2. Contemporaneously document why the allocation is defensible. Preferably get contemporaneous analyses of the underlying claims from the parties responsible for assessing them. Have the parties in the negotiations state the reasons for the assessments and do everything appropriate to insure that the reasons are defensible based on the state of the record and the state of the law at the time. Further, if possible, get the opposing side to agree in good faith with at least some of the broader parameters of the assessments by making an allocation that states both the allocated dollars and the basis for the allocations. Thus, in Srivastava, the Court said that "It is well settled that express allocations in a settlement agreement will be respected to the extent that the settlement agreement is entered into by the parties at arm's length and in good faith," citing Robinson. This may not be often done, but contemporaneously the facts probably exist that would permit it to be done by the parties without a great deal of extra work. Just as the plaintiff's side will have analyzed the various claims, so too will the defendant's. While many defendants just want a lump-sum settlement, their advisors have certainly advised them on the basis of assessments of the individual claims. This may be an imprecise science, but will be worth the effort to try to get some bona fide agreement to the parameters of the values of the claims and the basis for the values. Of course, in many cases, this will not be achievable, but you certainly will not get it if you don't ask. If you cannot get the other side's agreement, you should at a minimum have the plaintiff's attorneys and any other experts advising as to the settlement write up a contemporaneous memoranda as to their assessments of the claims, and, as noted, make sure the assessments stated in the memorandum must have a reasonable basis in reality.
3. The jury verdict as determinant may work in the taxpayer's favor. If, in the example discussed above, the assessments were reversed so that the Includable Claim was worth 90% and the Excludable Claim worth 10%, the taxpayer should be quite happy to accept the objective determinant and allocate the settlement 50-50. In this type of case, good lawyering would require entering a lump-sum settlement and, while not hiding the assessments of the claim, certainly not waiving a red flag. But, one might ask, what do you do about penalties? Can a taxpayer take a non-penalty return reporting position that the jury allocation controls? I would think so, at least until the law is clarified further on this issue. What is sauce for the goose is also sauce for the gander.
4. When prejudgment interest is at issue, using the Rozpad approach results in an understatement of the Includable Portion (i.e., the interest portion) based upon the time elapsing between the judgment on the jury verdict and the settlement. State regimes permitting prejudgment interest also allow postjudgment interest. If a judgment is outstanding, the relative amount of interest (including postjudgment interest) included in the total amount will go up. Hence, by delaying the settlement after the determination of interest pursuant to the jury verdict, the taxpayer should get economic value in the settlement for the delay (simply an interest factor), but will not suffer the tax on the full economic interest component because, under the Rozpad approach, the allocation is based on only the prejudgment interest component. Srivastava addressed this problem in the facts presented by requiring that post-judgment interest be factored in as a taxable element.