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Third Circuit Reverses Tax Court And Holds Taxpayers Received Tax-Exempt Interest on Deferred Payments From the Pennsylvania Department of Transportation Negotiated as Part of an Out-of-Court Settlement

Posted in Federal Tax Case Law Decisions



The Third Circuit, in partially reversing the Tax Court, in DeNaples v. Commissioner, 109 AFTR 2d 2012-1419 in a three judge panel opinion filed on March 19, 2012,  held that two couples were in receipt of tax-exempt interest income under §103 with respect to installment payments made under an out-of-court settlement agreement with the State of Pennsylvania that arose out of an eminent domain proceeding.  The holding that the amount of stated interest representing “delay damages” was not within §103, which was also determined by the Tax Court, was affirmed by the Third Circuit based on the taxpayers’ failure to meet its required burden of proof.


Code Section 103 (26 U.S.C.)



Section 103(a) of the Internal Revenue Code holds in relevant part: “gross income does not include interest on any State or local bond.” A “State or local bond” is defined in §103(c)(1) as “an obligation of a State or political subdivision thereof.” Since the inception of the Code in 1913, interest on obligations of states and their political subdivisions has been excluded from the interest recpient’s gross income. The rationale for the exclusion was to avoid a perceived unconstitutional burden on the borrowing power of state and local governments Drew v. United States, 551 F.2d 85, 87 (5th Cir. 1977); Holley v. United States, 124 F.2d 909, 911 (6th Cir. 1942).  As a tax exemption, which is true of any rule of income exclusion contained in the Code, the Courts have universally required the scope of the exclusion be narrowly construed. See, e.g., In re Hechinger Inv. Co. of Delaware, Inc., 335 F.3d 243, 259 (3d Cir. 2003) .


Factual Background in DeNaples v. Commissioner


The taxpayers, Dominick,Louis, Betty and Mary Ann DeNaples, through their ownership in several pass through entities, owned several parcels of  real property in Pennsylvania that was condemned by the Pennsylvania Department of Transportation (DOT) to facilitate the construction of the Lackawanna Valley Industrial Highway. In 1993 and 1994, to permit construction to go forward, the State and the DeNaples entered into two rights of entry, which permitted the State to enter onto the land but did not alter the DeNaples’ entitlement to just compensation. In 1998, the State initiated condemnation proceedings against the properties in the Pennsylvania Court of Common Pleas by filing a Declaration of Taking pursuant to former 26 Pa. Stat. § 1-402(a). The DeNaples objected, contending that the declaration did not adequately describe the property. The court agreed and dismissed some of the suits. On the remaining suits, a jury trial was commenced and then stayed when the parties indicated that they had settled.


On November 7, 2001, the parties signed a memorandum of intent to settle. The DeNaples agreed that, in exchange for all their ownership interest in all the parcels of land, they would receive compensation of approximately $40,900,000, of which $24,600,000 was allocated to principal, and $16,300,000 was allocated to interest (“settlement interest”). The condemnation proceeding record omitted how the allocation between principal and interest was determined and did not incorporate the settlement agreement. Instead the parties moved to dismiss the proceeding.


Payment was to be made in five annual payments, with the first payment of $8,100,000 plus accrued interest due by March 1, 2002, and the remaining four payments of $8,200,000 plus accrued interest due by March 1, 2003, 2004, 2005, and 2006. Interest accrued annually on the unpaid settlement amount at the rate set by (former) rule 238 of the Pennsylvania Rules of Civil Procedure (Pa. R. Civ. P. 238)(“interest on deferred payment amounts”).


The DOT paid the DeNaples each $10,111,193 in 2003, $9,289,353 in 2004, and $17,739,276 in 2005. The obligation was discharged in full a year earlier than required. On their 2003 through 2005 federal income tax returns, each taxpayer reported taxable interest income of $545,664, $545,664, and $1,091,328, respectively, and excluded from gross income $2,040,054, $1,629,134, and $2,838,545, respectively, as tax-exempt interest under §103 of the Code. More specifically, as to the settlement interest income, the DeNaples received approximately $4,300,000 for 2002 through 2004 and $8,700,000 for 2005. They excluded from gross income under §103 any interest received above 6% (the stated rate under former Pa. R. Civ. P. 238 on the stated interest amount of $16,700,000. As to the “interest on deferred payments”, the DeNaples excluded all of such interest income in computing gross income again based on Section 103.


The IRS, upon audit and review of the DeNaples returns for the years 2003 thru 2005, disagreed with the tax-exempt interest positions taken on the returns and issued a statutory notice of deficiency for $2,300,000 in underpayments in income tax against each couple for the years 2003 through 2005, comprised of $714,019 for 2003, $587,257 for 2004, and $1,023,299 for 2005.


Tax Court Memorandum Decision Issued by Judge Nims



After the case was fully stipulated and briefed before the Court, the Tax Court sided with the government and held that no part  of the “settlement interest” or “interest on deferred payments” was excludable from gross income as tax-exempt interest under Section 103. See DeNaples v. Comm’r, T.C. Memo. 2010-171.


As to the “settlement interest”, the Tax Court concluded that the DeNaples had failed to demonstrate that they received interest income above and beyond what was legally required and therefore the settlement interest was not an obligation of the State described within §103  because it did not invoke the State’s borrowing authority. It also found that the stated allocation to interest was excessive, i.e., the ratio of interest to principal approached 40%.


As to the “interest on deferred payments”,  Judge Nims held again that no amount was excludable under §103 finding that the DeNaples were entitled to be compensated for agreeing to receive the settlement payments in installments where the "interest" on the deferred payments was  part of their right to just compensation. Accordingly, the Tax Court entered an order affirming the IRS’ deficiency calculations in full.


The DeNaples’ then filed a  motion for reconsideration which was denied.  Tax Court refused to reopen the record to allow the taxpayers to introduce evidence of the prevailing commercial rate of interest as proof that a portion of the settlement interest was excludable from gross income. It held that to recompute the deficiencies in tax for each year as part of a Rule 155 computation would inappropriately allow the taxpayers to introduce evidence that it failed to produce at trial.  The Tax Court found that the DeNaples had therefore failed to meet their burden of proof that the deficiency was inaccurate with respect to the “interest on deferred payments”. T.C. Memo. 2011-46 (2011).


The taxpayers filed an appeal to the Third Circuit, which heard the case de novo as to the Tax Court’s findings of law and the construction and application of the Internal Revenue Code and under the clear error standard for factual findings and inferences drawn therefrom.  PNC Bancorp, Inc. v. Comm’r, 212 F.3d 822, 827 (3d Cir. 2000)


The Third Circuit Court of Appeals Reverses In Part the Tax Court Memorandum Decision


The Third Circuit reversed in part and affirmed in part the lower court’s decision.


In reviewing applicable precedent in the area, the Third Circuit noted its reliance on a long-standing Supreme Court decision in Helvering v. Stockholms Enskilda Bank, 293 U.S. 84, 86-87,  which requires for purposes of §103,  an “obligation” of a state or local government should not be “extended to include interest upon indebtedness not incurred under the borrowing power”.  Where, however, the state or local governmental authority’s borrowing power is the source for the obligation to pay interest, then interest on the underlying indebtedness falls within the exemption. In contrast, where, for example,  a state’s obligation to pay interest arises by operation of law, the state’s borrowing power is not implicated and §103 is unavailable. Where the state’s obligation to pay interest is part of a voluntary negotiation, howeer, its obligation to pay interest does find as its source the state’s borrowing authority and may be excludable §103.


After laying out the ground rules for determining whether interest paid by a state or governmental body as part of a settlement of an eminent domain proceeding falls within §103, the Third Circuit focused on  Pennsylvania law on eminent domain proceedings. It observed, that in many instances, the state’s obligation to pay interest in a condemnation proceeding arises by operation of law. This occurs where the state delays in making payment of the just compensation amount which entitles the condemnee to interest by operation of law.  Hughes v. Dep’t of Transportation, 523 A.2d 747, 753 (1983)(where owner can prove under former law that the statutory 6% rate is insufficient, a higher rate of interest on delayed condemnation payments may be established as part of just compensation award). See Wasserott v. PennDOT, 13 Pa. D. & C. 4th 593, 595 (Ct. Com. Pl. 1991). In Hughes, supra, the Supreme Court of Pennsylvania ruled, aligning itself with a majority of jurisdictions, that “ if the property owner produces evidence that the 6% rate is constitutionally insufficient, he should be entitled to a higher rate of return as just compensation”.  Where interest is owed by the condemning authority by operation of law, the interest is not excludable under §103. See 26 Pa. Cons. Stat. §713 (2006)(interest rate for delay damages changed to prime plus 1%).


            Interest on Deferred Payments


Resolving the question of whether §103 applied to interest on deferred payments received by the DeNaples would turn, in the view of the Third Circuit, on whether the DOT’s interest obligation arose by operation of law or was solely the product of voluntary bargaining. The record below established that the DOT and the DeNaples negotiated a complete arms-length settlement of Pennsylvania’s claims. The DeNaples agreed, as part of the out-of-court settlement agreement, to receive a lower, variable interest rate for the purpose of extending credit to Pennsylvania and not a higher rate that would have applied under then statutory rule. Therefore, interest on the deferred payments under the facts of the case met the requirements under §103. This portion of the Tax Court’s decision was reversed. The Third Circuit noted that the same analysis was essentially adopted by the Ninth Circuit in Stewart v. United States, 739 F.2d 411, 414 (9th Cir. 1984).


In elaborating on its voluntary negotiation rationale, the Third Circuit looked at the DeNaples and the DOT as having entered into an arms-length settlement agreement, albeit in the “shadow of the ongoing condemnation proceeding with its attendant rights and obligations, including the DeNaples’ right to interest for any payment delay.” However, the taxpayers agreed to a rate of interest on deferred payments as part of the bargain and that bargain implicated the State of Pennsylvania’s borrowing authority. Thus, the interest paid on the deferred payments was not part of a judicial award of just compensation which would fall outside of  §103. In this case the State’s obligation to pay interest at a fixed rate did not arise by operation of law but instead by a  “freely-negotiated contract that contemplated no further judicial intervention.”  


In distinguishing the case at bar from the government’s reliance on the Sixth Circuit’s decision in Holley v. United States, supra, the Third Circuit noted that in Holley a settlement agreement between the condemning authority and the condemnee was part of the court’s order or award whereas in this case DeNaples and Pennsylvania agreed to a total settlement which extinguished the condemnation proceeding. No court award of “interest” was made as the condemnation proceeding was “settled, discontinued and ended”. The Third Circuit viewed that this difference was critical to its reaching its conclusion. A quote from the Court’s opinion drives home this distinction:


“ To be clear, we do not hold that any interest payment made pursuant to a voluntary settlement agreement is automatically excludable under Section 103. Rather, it is excludable here because, given the nature of how and what the parties agreed to in the settlement agreement, it is clear that the obligation to pay interest at the Rule 238 rate arose not by operation of law but through the voluntary, arms-length negotiations between the DeNaples and Pennsylvania.”


Settlement Interest


The Tax Court’s holding on the “settlement interest” of $14,000,000 stated in the settlement agreement as not constituting tax exempt interest was affirmed. The Third Circuit also held that the Tax Court did not err when it refused to reopen the record by rejecting the taxpayers’ motion for reconsideration to receive evidence about the prevailing commercial loan rate.


The taxpayers argument was that the “settlement interest” agreed to by the parties compensated them for the delay between the time of the initial right of entry and the entering into the settlement agreement. Based on the former Rule 238’s reference to a  6% rate under Pennsylvania law which Rule was applicable at the time, the DeNaples excluded from their gross income only the delay interest in excess of 6%. The taxpayers viewed that since the 6% rate was required by law for delay payments, interest above 6% was the product of voluntary bargaining.  


The Third Circuit agreed with Judge Nims’ opinion on this issue on several grounds. First, it agreed with the fact finding that the allocation made by the parties between interest and principal was arbitrary and excessive. Second, it rejected the taxpayers efforts in its motion for reconsideration to recalculate what the proper amount of interest would be based on prevailing commercial rates of interest for the years in issue. Such evidence was not produced at trial. The taxpayers simply failed to meet their burden of proof that the amount of the deficiency was incorrect. Finally, it agreed that an effort to recompute the deficiency under the guise of a Tax Court Rule 155 recomputation was outside of the scope and purpose of such provision. Rule 155 does not permit either party to have what is in effect an opportunity for retrial of what was left off the record.   Blonien v. Comm’r, T.C. Memo. 2003-308;  Paccar, Inc. v. Comm’r, 849 F.2d 393, 400 (9th Cir. 1988).  


Both the Tax Court as well as the Third Circuit left open the thought that if the State or governmental authority enters into a voluntary agreement awarding just compensation as well as delay damages, the interest representing the delay damages computation may implicate the condemning authority borrowing authority and fall within §103 if the interest amount is reasonable based on prevailing commercial rates, the parties voluntary negotiated the rate of interest as part of an arms length bargain, and the agreement, once reached, was not incorporated in a court order.