United States Court of Appeals
                            FOR THE EIGHTH CIRCUIT
                                    ___________

                                    No. 96-1768
                                    ___________

Hughes A. Bagley and                  *
Marilyn B. Bagley,                    *
                                      *
          Appellants,                 *
                                      * On Appeal from the
    v.                                * United States Tax Court.
                                      *
                                      *
Commissioner of Internal Revenue,     *
                                      *
          Appellee.                   *
                                 ___________

                              Submitted: June 9, 1997

                                   Filed: August 6, 1997
                                    ___________

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 Court1 held that
$500,000 of the settlement was not excludable, Bagley v. Commissioner, 

(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.), 

(8th Cir. 1986) (en banc), reh'g denied, 

(1986) (en banc), cert. denied, 

(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


      1
       The Honorable Irene F. Scott, Judge, United States Tax Court.
                                          -2-
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

                                           -3-
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, 

(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." 

. 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." 

       2
       The Tax Code now expressly states that punitive damages are not excludable
from income. See 26 U.S.C. § 104(a)(2).
       3
        The Commissioner does not contest the Tax Court's decision on appeal.
                                          -4-
                                            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, 

, 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


       4
        Bagley's failure to appeal the original dismissal of the invasion-of-privacy award
allowed the dismissal to become final and thus created some uncertainty about whether
the District Court could have reinstated the invasion-of-privacy award if Bagley lost the
libel suit. The Bagleys plausibly argued, and the District Court seemed inclined to
agree, that the District Court could reinstate the judgment under Federal Rule of Civil
Procedure 60(b)(5), authorizing relief from a final judgment where the judgment was
based upon "a prior judgment" that has since "been reversed or otherwise vacated."
Because the invasion-of-privacy award had been dismissed only because the District
Court found it to be duplicative of the libel award, and because the libel judgment that
was the basis for the dismissal of the invasion-of-privacy judgment had been reversed
by this Court, Bagley had a plausible argument that the District Court could use Rule
60(b)(5) to reinstate the invasion-of-privacy award if he ultimately failed to prevail on
his libel claim. Thus, while the reinstatement of the invasion-of-privacy award was not
a sure thing, it was a likely enough prospect to be worth something in settlement.
       5
       As the Commissioner points out, this Court's reversal of the libel claim had
nothing to do with the amount of the claim. Thus, there was no legal bar to Bagley's
recovering the same amount if he prevailed on retrial. The Bagleys argue that the
second trial might have been different because evidence admitted solely to prove other
claims at the first trial would not have been available to Bagley at the retrial of the libel
claim. The Bagleys present no evidence, however, that the expected absence of this

                                            -5-
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


evidence at the second trial materially affected the lawyers' estimation of the likelihood
that Bagley would have received a significant amount of punitive damages if he won
his libel claim on retrial.
       6
       In McKay v. Commissioner, 

(1994), vacated on other grounds,

(5th Cir. 1996) (unpublished), for example, the settlement agreement was
far more explicit that the defendant did not intend to pay punitive damages in
settlement, and the Tax Court upheld the allocation:

              McKay has necessarily acceded to Ashland's demand that
              nothing be allocated to the RICO claim, punitive damages

                                            -6-
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
plaintiffs will not want specific allocations to punitive damages in their settlement
agreements, because punitive damages are taxable. Therefore, when the time comes to
settle a case, no matter how adversarial the proceedings have been to that point, the
parties will almost always be in agreement that no part of a settlement agreement should
be explicitly allocated to punitive damages.7

       The Bagleys also rely on the statement of IBP's lawyer during the settlement
negotiations that if Bagley wanted punitive damages, he would have to go to trial. One
is tempted to dismiss such a statement as a negotiation tactic. IBP's general counsel
stated that IBP's goal in settlement negotiations was simply to settle for the lowest
amount possible, and the Bagleys do not point to any other evidence suggesting that
IBP's desire to avoid an allocation to punitive damages was especially strong. The Tax
Court found that "counsel for IBP did not want to show an allocation to punitive
damages" and that "it was clearly in the interest of both parties not to show an amount
allocated to punitive damages." 

. Even so, IBP was not in a position



              claims, or alleged intentional misconduct claims and
              Ashland and McKay have both relied upon their appellate
              counsel's consensus estimate of McKay's probability of
              appellate success with respect to the [claims that defendant
              Ashland agreed to pay.]

(quoting settlement agreement).

       7
        Indeed, IBP's attorney, an experienced Iowa litigator, told the Tax Court that he
could recall no settlement with which he had been involved that specifically allocated
a certain amount to punitive damages in the settlement agreement. Appellants' Br. 44.

                                          -7-
to demand that punitive damages not figure into the amount of the settlement, since the
prospect of punitive-damages liability was so likely no matter what the result of the
pending libel trial. Proof of IBP's desire to avoid an express allocation to punitive
damages cannot overcome the evidence that IBP necessarily paid more to settle Bagley's
claims against it because of the very real threat of punitive-damages liability that it
faced.

        A final piece of evidence that part of the settlement reflects the payment of
punitive damages is that IBP paid $500,000 more to settle Bagley's claims than the jury
had awarded in compensatory damages on the libel claim, the largest of the three
awards. While it is theoretically possible that the jury might have awarded even more
in compensatory damages on retrial of the libel claim and nothing in punitive damages,
it is far more likely that IBP paid the extra $500,000 to settle the punitive-damages
liability it faced.

       Finally, the differences between this case and 

, 

,
which the Bagleys cite in support of their claim, are instructive. In McKay, a jury
awarded the taxpayer close to $14.5 million in compensatory damages, $1,250,000 in
punitive damages, and $43 million for the defendant's violation of RICO. In settlement
negotiations after the verdict, the defendant was adamant that no part of the settlement
be allocated to punitive damages or the RICO claim, and the settlement agreement
expressly reflected that sentiment. The agreement allocated $14,294,300 to
compensatory damages and nothing to punitive damages, and the Tax Court upheld this
allocation. 

       Several facets of this case distinguish it from McKay. First, the Tax Court found
in McKay that the taxpayer "desired that a portion of the settlement proceeds be
allocated to the RICO claim in order to publicize [the defendant's] unlawful activity."

. Thus, unlike in the present case where neither side wanted a specific
allocation to punitive damages in the settlement agreement, the parties in McKay were

                                          -8-
genuinely adverse as to the issue of how to allocate the settlement proceeds, and so the
Court could properly assume that the agreement reflected the reality of the situation.
Second, the agreement in McKay expressly stated both that none of the settlement went
to punitive damages and that the parties came to that conclusion based upon their
attorneys' estimates of the probability of appellate success on the punitive claims. Third
and finally, unlike in this case, the amount of settlement in McKay (less the amount
allocated to attorneys' fees) was less than the jury had awarded in compensatory
damages, thus making it plausible that the defendant had agreed to pay only
compensatory damages.

                                           III.

       The Bagleys argue only that none of the settlement in this case was taxable. They
do not suggest an alternative amount that the Tax Court should have awarded between
nothing and $500,000. We cannot say that $500,000 was not the proper amount. It
gave the taxpayer the benefit of the largest amount that the jury had awarded in
compensatory damages, and thus the largest amount that could plausibly be allocated
to compensatory damages. See Robinson v. Commissioner, 

, 38 (5th Cir.
1995) (Tax Court did not err in basing settlement allocation upon jury verdict, "the best
indicator of the worth of the [taxpayers'] claims."), cert. denied, 

(1997).
The judgment of the Tax Court is

      Affirmed.


      A true copy.


             Attest:


                     CLERK, U.S. COURT OF APPEALS, EIGHTH CIRCUIT.

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