Third Circuit Reverses Tax Court In Tax Exempt Interest Case

Mar 21, 2012   

On March 19, 2012, a panel of the U.S. Court of Appeals for the Third Circuit reversed the Tax Court which had held that Internal Revenue Code section 103 did not exempt from federal taxation the interest payments the Commonwealth of Pennsylvania had made to the taxpayers at issue in the case.  Judge Fuentes authored the opinion on behalf of the Third Circuit.

The facts are as follows:

The taxpayers were equal partners in various entities.  These entities owned an interest in several parcels of real property in Pennsylvania. The Commonwealth of Pennsylvania, through the Pennsylvania Department of Transportation, sought to acquire the property to build the Lackawanna Valley Industrial Highway. In 1993 and 1994, to allow construction to go forward, the Commonwealth and the taxpayers entered into two Rights of Entry, which permitted the Commonwealth to enter onto the land but did not alter the taxpayers  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 taxpayers 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 but then stayed when the parties indicated that they had settled.

On November 7, 2001, the parties signed a memorandum of intent to settle. The taxpayers agreed that, in exchange for all their ownership interest in all the parcels of land, they would receive compensation of approximately $40.9 million, of which $24.6 million would be allocated to principal, and $16.3 million would be allocated to interest (“settlement interest”).

Because the Commonwealth lacked sufficient funds available to pay the settlement in full, the taxpayers agreed to accept the settlement money in five installment payments. By their agreement, each installment payment would be subject to the interest rate set forth in Rule 238(a)(3) of the Pennsylvania Rules of Civil Procedure, which governs the interest rate for tort suits (“installment interest”).

The Commonwealth made timely and complete payments under the agreement and, in fact, paid the remainder of the amount due in 2005, a full year early. The taxpayers filed income tax returns for tax years 2003 through 2005, and excluded from their gross income a portion of the settlement interest income and all of the installment interest income they had received.

The taxpayers excluded from their federal gross income any interest received above 6%, contending that anything above this rate was exempt as an obligation of the Commonwealth under Section 103. The taxpayers excluded all the installment interest income from their gross income calculations as exempt under Section 103. In 2008, the IRS issued deficiency notices to the taxpayers.

The Tax Court, in a written opinion, available here, held that no part of the settlement interest is excludable from the taxpayers gross income under Section 103. 

Section 103(a) simply states that:  Except as provided in subsection (b), gross income does not include interest on any State or local bond. A Section 103 is available in full here.

On appeal, the Third Circuit held that because the taxpayers agreed to a lower, variable interest rate for the purpose of extending credit to Pennsylvania, the Commonwealths obligation arose by voluntary bargaining, not by operation of law.  As a result, because the Commonwealths interest obligation was a voluntary one which allowed it to borrow money from the taxpayers, the Section 103 exclusion was appropriate. 

A full copy of the Third Circuits decision is available here.

The takeaway from this case is that good appellate advocacy in taxation appeals can, and has, resulted in the Tax Court being reversed.  The attorneys at Fuerst Ittleman have extensive experience litigating before the U.S. Courts of Appeals, and the firm is currently litigating tax cases before the Third, Fourth, and Eleventh Circuit Courts, in addition to the U.S. Supreme Court.  You can contact an attorney by emailing us at: or by calling us at: 305.350.5690.