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DeNAPLES v. C.I.R.
674 F.3d 172 (2012)
Dominick DeNAPLES and Mary Ann DeNaples, Petitioners
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent.
Louis DeNaples and Betty A. DeNaples, Petitioners
v.
Commissioner of Internal Revenue, Respondent.
Dominick DeNaples, Mary Ann DeNaples, Louis DeNaples, and Betty A. DeNaples, Appellants.
Nos. 11-2205, 14357-08, 14359-08.
United States Court of Appeals, Third Circuit.
Argued November 16, 2011.
Filed: March 19, 2012.
Layla J. Aksakal, David B. Blair, Alan I. Horowitz, (Argued), Joel C. Weiss, Miller & Chevalier, Washington, DC, Barry H. Frank, Archer & Greiner, Philadelphia, PA, for Petitioners-Appellants Betty DeNaples, Dominick DeNaples, Louis DeNaples, Mary Ann DeNaples.
Before: FUENTES, CHAGARES, Circuit Judges, and RESTANI, Judge.*
OPINION OF THE COURTFUENTES, Circuit Judge. Dominick, Louis, Betty, and Mary Ann DeNaples had an interest in real estate in Pennsylvania which the state condemned as part of the construction of the Lackawanna Valley Industrial Highway. To pay for the land, the state agreed to a settlement under which it would pay them $40.9 million, with interest, in five yearly installments. During the first three years of the agreement, the DeNaples excluded this interest from their federal income taxes as tax exempt interest under I.R.C. § 103, which permits exclusion of interest payments that are obligations of the state. The IRS issued to each couple a deficiency notice for $2.3 million, which was affirmed by the Tax Court. On appeal, the principal issue is whether Section 103 exempts from federal taxation the installment interest paid under an agreement that allowed the state to make yearly payments. We hold that it does. I.The facts are not in dispute and were stipulated to before the Tax Court. Dominick DeNaples and Louis DeNaples were equal partners in D & L Realty, Rail Realty, Inc., F & L Realty, Inc., and Keystone Company.1 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 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 received 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"). There is nothing in the record that indicates why these numbers were selected.
* Honorable Jane A. Restani, Judge of the United States Court of International Trade, sitting by designation.
1. Dominick DeNaples is married to Mary Ann DeNaples, and Betty DeNaples is married to Louis DeNaples. Each couple filed a joint tax return. For our purposes, they are indistinguishable as Dominick and Louis owned equal shares in the partnership, reported the same interest income, and were issued the same deficiency notice. When we refer to the DeNaples, we refer to them jointly.
2. The interest rate is "the rate equal to the prime rate as listed in the first edition of the Wall Street Journal published for each calendar year for which the damages are awarded, plus one percent, not compounded." Pa. R. Civ. P. 238(a)(3) (2002). In 2002, the prime interest rate was 4.75%; in 2003, the interest rate was 4.25%; in 2004, it was 4.00%; in 2005, it was 5.25%; in 2006, it was 7.25%. Money Rates, Wall St. Journal, Jan. 2, 2002; Money Rates, Wall St. Journal, Jan. 2, 2003; Money Rates, Wall St. Journal, Jan. 2, 2004; Money Rates, Wall St. Journal, Jan. 3, 2005; Money Rates, Wall St. Journal, Jan. 3, 2006. Thus, the installment interest rate that Pennsylvania paid for years 2002 through 2006 were 5.75%, 5.25%, 5.00%, 6.25%, and 8.25%, respectively.
3. The record before this Court does not contain a copy of the stipulation that the court was to enter. However, it could not modify any provision of the agreement because, according to the terms of the agreement, modification required the written agreement of both parties.
4. In 2006, Pennsylvania enacted a new statute whereby the interest rate for delay damages is the prime interest rate plus 1%. 26 Pa. Cons. Stat. § 713 (2006).
5. In Stewart II, the Ninth Circuit found whether the settlement was entered into because the State needed credit to be a material fact that altered the application of Section 103 to a condemnation settlement. Stewart v. United States, 739 F.2d 411, 414 (9th Cir. 1984). The Commissioner attempts to distinguish this case by pointing out that in Stewart II, condemnation proceedings were only threatened while here they had been commenced. This, the Commissioner argues, demonstrates that the transfer was obligatory not voluntary. While the Government is correct that the DeNaples were going to be obligated to sell their property to Pennsylvania, the DeNaples had a choice over the terms by which they did so, including whether they would receive interest and at what rate. They could have proceeded to judgment and obtained a judicially mandated just compensation award with statutory interest. Instead, they voluntary bargained with the State because the State needed an extension of credit to pay any award. Thus, the distinction is not dispositive here.
6. By surrendering its property in exchange for a promise of future payments, the DeNaples extended credit to Pennsylvania. Credit is the "provision of ... goods ... with the expectation of future payment." Merriam-Webster Online Dictionary, available at http:// www.merriam-webster.com/dictionary/credit; see also Pollice v. Nat'l Tax Funding, L.P., 225 F.3d 379, 412 (3d Cir.2000) ("[T]he definition of `credit,' however encompasses ... [the] right granted by a creditor to incur debt and defer its payment....") (internal quotation marks omitted).
7. As the Commissioner argues, recalculation of the settlement amount might require further evidence, such as the fair market value of the property at the time of taking. While we do not necessarily agree, we note that this would only bolster our holding.
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