Installment interest from settlement with state is tax-exempt

The Third Circuit Court of Appeals, reversing the Tax Court, held that a state that paid taxpayers installment interest on amounts owed pursuant to an eminent domain settlement did so under its borrowing authority, and the interest therefore was tax-exempt. According to the court, the interest was paid due to a voluntary agreement between the taxpayer and the state, not due to the operation of state law, and thus invoked the state’s borrowing power.

Sec. 103 excludes from gross income interest earned on the obligations of state and local governments. The interest must have been paid under the government’s borrowing power, which occurs when the interest results from voluntary bargaining. The interest is not excludable if it is incurred due to the operation of law, such as under a state law requiring the state to pay a fixed interest rate when there is a delay in the payment of condemnation proceeds after property has been taken under eminent domain.

Dominick and Louis DeNaples were equal partners in four realty companies in Pennsylvania. From 1993 to 1998, the Pennsylvania Department of Transportation (PennDOT) took by eminent domain property owned by the realty companies. The companies objected but reached a settlement with PennDOT in 2001 that required PennDOT to pay the entities $40.9 million—$24.6 million allocated to principal and $16.3 million to interest from the time of the taking until the settlement (settlement interest). Since the state lacked sufficient funds, the companies agreed to receive $8.1 million plus accrued interest (installment interest) in 2002 and four payments of $8.2 million each plus accrued interest in 2003, 2004, 2005, and 2006. From 2003 to 2005, each taxpayer excluded interest totaling $6,507,733 (a portion of the settlement interest and all of the installment interest) from his individual tax return.

The IRS assessed deficiencies on the basis that all of the interest was taxable. The taxpayers petitioned the Tax Court for relief; however, it agreed with the IRS (DeNaples, T.C. Memo. 2010-171). The court held that the taxpayers failed to show that any of the settlement interest exceeded the amount the state was required to pay by law and that the settlement interest appeared to be arbitrarily determined by the taxpayers and PennDOT rather than being based on any interest computation. In addition, the court held that the installment interest was taxable, since the state of Pennsylvania was required by law to pay interest on the installment payments. The taxpayers appealed the decision to the Third Circuit.

The appellate court upheld the Tax Court’s decision that the settlement interest was taxable but reversed the Tax Court regarding the installment interest. The court held that the installment agreement was the result of voluntary negotiations between Pennsylvania and the taxpayers because the parties negotiated it due to the state’s inability to pay the entire $40.9 million at the date of settlement. The agreement extinguished the eminent domain proceeding and thus was entered into outside it, the court concluded. Thus, according to the court, the state’s obligation to pay interest was the result of a freely negotiated contract that invoked the state’s borrowing authority, as opposed to the operation of state law.

DeNaples, 674 F.3d 172 (3d Cir. 2012)

By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota–Duluth.