                  T.C. Memo. 2010-171


                UNITED STATES TAX COURT



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



Docket Nos. 14357-08, 14359-08.   Filed August 3, 2010.



     Ps’ property was taken by eminent domain, and they
reached a settlement on the amount of compensation, along
with an amount designated as interest (settlement interest).
Ps received installment payments, along with interest
accruing at the rate provided for in Pa. R. Civ. P. 238
(installment payment interest). Ps argue that the portion
of the settlement interest in excess of the legally required
interest is excludable from their gross income under sec.
103, I.R.C. Ps also argue that all of the installment
payment interest is excludable under sec. 103, I.R.C.,
because it was not required by law and was paid under the
State’s borrowing power.

     Held: No part of the settlement interest is excludable
from Ps’ gross income under sec. 103, I.R.C.
                                  -2-

          Held, further, the interest on installments is not
     excludable from Ps’ gross income under sec. 103, I.R.C.



     Barry H. Frank, for petitioners.

     Peter James Gavagan, for respondent.



                        MEMORANDUM OPINION


     NIMS, Judge:   Respondent determined deficiencies in the

income tax of Dominick and Mary Ann DeNaples of $714,019 for

2003, $587,257 for 2004, and $1,023,299 for 2005.      Respondent

also determined deficiencies in the income tax of Louis and Betty

A. DeNaples of $714,019 for 2003, $570,197 for 2004, and

$1,023,298 for 2005.

     The issues for decision are:       (1) Whether any portion of an

eminent domain settlement amount designated as interest is

excludable from petitioners’ gross income under section 103; and

(2) whether interest accruing on the settlement amount and

included in the installment payments is excludable from their

gross income under section 103.    Unless otherwise indicated, all

section references are to the Internal Revenue Code in effect for

the years in issue, and all Rule references are to the Tax Court

Rules of Practice and Procedure.
                                 -3-

                              Background

     These cases were consolidated and submitted fully stipulated

pursuant to Rule 122.   The stipulations of the parties, with

accompanying exhibits, are incorporated herein by this reference.

Petitioners resided in Pennsylvania at the time they filed their

petitions.

     Dominick and Louis DeNaples (petitioners) each owned a 50-

percent partnership interest in D&L Realty (D&L), a 50-percent

interest in a joint venture named Keystone Co. (Keystone), and 50

percent of the S corporation stock of Rail Realty, Inc. (Rail

Realty).   Rail Realty was the sole shareholder of F&L Realty,

Inc. (F&L), a qualified subchapter S subsidiary.

     In connection with the construction of the Lackawanna Valley

Industrial Highway, the Pennsylvania Department of Transportation

(PENNDOT) sought to acquire property (Keystone Landfill) owned by

Keystone, D&L, and F&L (the condemnees).    PENNDOT took the

property by eminent domain by filing a series of declarations of

taking from 1993 to 1998.

     The condemnees filed objections to the taking and ultimately

settled with PENNDOT.   Under the settlement PENNDOT agreed to a

$40,900,000 payment (the settlement amount) as of November 7,

2001 (the settlement date).    Pursuant to the agreement of the

parties, the settlement amount was allocated $24,638,555 to

principal and $16,261,445 to interest (settlement interest).
                               -4-

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 rule 238 of the Pennsylvania Rules of Civil Procedure (Pa. R.

Civ. P. 238).

     PENNDOT paid petitioners1 each $10,111,193 in 2003,

$9,289,353 in 2004, and $17,739,276 in 2005.   On their 2003

through 2005 Forms 1040, U.S. Individual Income Tax Return, each

petitioner 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 section 103.

     On March 20, 2008, respondent issued notices of deficiency

to each petitioner determining that the excluded interest was not

tax exempt.

                           Discussion

     To be successful in this controversy, petitioners must show

that the State of Pennsylvania incurred the obligation to pay

interest in the exercise of its borrowing authority.




     1
      According to the settlement, petitioners were responsible
for distributing the installment payments to the condemnees.
                                -5-

Petitioners argue that a portion of the settlement interest and

the whole of the installment payment interest are excludable from

income.

I.   Settlement Interest

      When property is taken under eminent domain, the owner is

entitled to just compensation, which includes interest from the

date of the taking to the date of payment.     United States v.

Thayer-West Point Hotel Co., 329 U.S. 585, 588 (1947); Seaboard

Air Line Ry. Co. v. United States, 261 U.S. 299, 306 (1923).

Three types of damages may be available to the property owner

whose land has been taken for public use:

      Upon appropriation, * * * [the property owner] acquires an
      immediate right to the fair market value of the land.
      * * *

           The property owner may also be entitled to recover
      damages, traditionally called detention damages, from the
      date of the taking of the property to the date of the award
      as compensation for the detention of the landowner’s money.
      * * * Finally, the property owner may receive interest from
      the date of the award to the date of payment. * * * [In re
      De Facto Condemnation & Taking of Lands of WBF Associates,
      L.P., 903 A.2d 1192, 1199 (Pa. 2006).]

Detention damages plus interest from the date of the award are

collectively referred to as “delay damages”.     Id.

      Section 103 excludes from gross income interest earned on

the obligations of any State or its political subdivision.    Sec.

103(a), (c)(1).   The exclusion is limited to interest paid by a

governmental entity on obligations issued under its borrowing

authority.   Stewart v. Commissioner, 714 F.2d 977, 981 (9th Cir.
                                  -6-

1983), affg. T.C. Memo. 1982-209; King v. Commissioner, 77 T.C.

1113, 1118 (1981).    Courts determine whether the agency’s

obligation to pay interest arises by operation of law or as a

result of voluntary bargaining.    Courts have uniformly held the

section 103 exclusion inapplicable to interest paid in connection

with condemnation proceedings.    See Stewart v. Commissioner,

supra; Drew v. United States, 551 F.2d 85 (5th Cir. 1977); Holley

v. United States, 124 F.2d 909 (6th Cir. 1942); Balt. & Ohio R.R.

Co. v. Commissioner, 78 F.2d 460 (4th Cir. 1935), affg. 29 B.T.A.

368 (1933); U.S. Trust Co. of New York v. Anderson, 65 F.2d 575

(2d Cir. 1933); King v. Commissioner, supra.

       Petitioners contend that 26 Pa. Stat. Ann. sec. 1-611 (West

2006) required a 6-percent rate of interest on delay damages.

Petitioners’ argument assumes that the settlement interest should

be bifurcated:    One portion of the interest is that required by

Pennsylvania law (legally required interest), and the other

portion is the excess over that amount (excess interest), which

should be tax exempt under section 103.    Petitioners reason that

the excess interest did not arise by operation of law but rather

as the product of voluntary bargaining between petitioners and

PENNDOT.    Using that reasoning, petitioners contend that the

excess interest was paid in connection with Pennsylvania’s

borrowing authority and is therefore excludable under section

103.
                                -7-

     To be successful petitioners must show, as an initial

matter, that the settlement interest was in excess of the legally

required interest.   They have failed to do so and are incorrect

in relying on 26 Pa. Stat. Ann. sec. 1-611 for the legal rate of

interest on delay damages.   In Hughes v. Commonwealth Dept. of

Transp., 523 A.2d 747 (Pa. 1987), the Pennsylvania Supreme Court

held the 6-percent rate of 26 Pa. Stat. Ann. sec. 1-611 to be

unconstitutional and required the use of the prevailing

commercial loan rate instead.   Because the record does not

indicate (1) what the commercial loan rate was during the years

in issue2 and (2) what interest rate petitioners and PENNDOT

actually used, petitioners have not established that PENNDOT paid

“excess interest”.

     Although petitioners submitted calculations from which a

purported rate of interest could be calculated, we do not find

these calculations to be satisfactory.   Petitioners have

presented no evidence upon which to base their calculations, and

the settlement allocations appear to be the product of an



     2
      Though not established by the record, it appears that
petitioners and PENNDOT used the Pa. R. Civ. P. 238 rate as a
proxy for the commercial loan rate. The Pa. R. Civ. P. 238 rate
is “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.”
Commercial loan rates are based on the prime rate and are
typically between prime plus 1 percent to prime plus 3 percent.
See Hagan v. E. Pennsboro Twp., 713 A.2d 1187, 1191 (Pa. Commw.
Ct. 1998).
                                -8-

arbitrary assignment by petitioners and PENNDOT rather than a

mathematical computation of interest.

     Petitioners’ calculations indicate that PENNDOT paid:    (1)

$11,342,365 of interest for a 1,044-day delay on the payment of

the $17,185,384 fair market value of Keystone’s share of Keystone

Landfill; (2) $1,260,263 of interest for a 1,044-day delay on the

payment of the $1,909,487 fair market value of F&L’s share of

Keystone Landfill; (3) $3,622,240 of interest for a 2,382-day

delay on the payment of the $5,488,236 fair market value of D&L’s

share of Keystone Landfill’s mineral rights; and (4) $36,588 of

interest for a 1,893-day delay on the payment of the $55,437 fair

market value of F&L’s share of Keystone Landfill’s mineral

rights.

     On the basis of these numbers, the interest rates would have

been approximately 23.1, 23.1, 10.1, and 12.7 percent,

respectively.   There is no explanation in the record for the

difference in interest rates.   More significantly, a close

examination of petitioners’ interest amounts reveals that the

length of the delay in payment was not factored into the

computation of the amount of “interest”.   For each of these four

ownership interests in Keystone Landfill, the same ratio

(approximately 39.759 percent) was allocated to “interest”

without any regard for the number of days payment had been

delayed.
                                 -9-

      Accordingly, we hold that petitioners are not entitled to

exclude from their gross income the amounts designated settlement

interest under section 103.

II.   Installment Payment Interest

      The second prong of petitioners’ argument is that the

installment payment interest was not required by law because Pa.

R. Civ. P. 238 does not apply to eminent domain proceedings.      On

the basis of that argument, petitioners conclude that the

installment payment interest was the product of voluntary

bargaining and paid pursuant to Pennsylvania’s borrowing power.

      The premise for their conclusion, however, is incorrect.

While Pa. R. Civ. P. 238 does not create a legal requirement to

pay interest from the settlement date, the just compensation

requirement under the United States and Pennsylvania

Constitutions does.    See U.S. Const. amend. V; Pa. Const. art. I,

sec. 10.    Just compensation entails payment of delay damages,

which includes interest from the date of the award (i.e., the

settlement date) to the date of payment.    See In re De Facto

Condemnation & Taking of Lands of WBF Associates, L.P., 903 A.2d

at 1199.    Thus, by operation of law, Pennsylvania was required to

pay interest on the installment payments.

      Accordingly, we hold that petitioners may not exclude from

their gross income any portion of the installment payment

interest.    They did not produce evidence of the prevailing
                                 -10-

commercial loan rates during the years in issue and have not

shown that the State of Pennsylvania incurred the obligation to

pay interest in the exercise of its borrowing power.

     Our consideration of whether petitioners are entitled to

bifurcate the installment payment interest is obviated by our

holding that no portion of that interest was shown to be in

excess of the amount required by operation of law.

     To reflect the foregoing,


                                        Decisions will be entered

                                 for respondent.
