Academic journal article Journal of Accountancy

Installment Interest from Settlement with State Is Tax-Exempt

Academic journal article Journal of Accountancy

Installment Interest from Settlement with State Is Tax-Exempt

Article excerpt

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. …

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