Opinion
Civil Action No. 19-cv-00714-RMR-MEH
2021-12-08
Charles BELLOCK, et al., Plaintiff, v. UNITED STATES of America, Defendant.
Cory Lyn Johnson, Jason A. Harn, John Mark Colvin, Colvin & Hallett Law, Seattle, WA, for Plaintiff. Charles J. Butler, Ty Halasz, U.S. Department of Justice, Washington, DC, for Defendant.
Cory Lyn Johnson, Jason A. Harn, John Mark Colvin, Colvin & Hallett Law, Seattle, WA, for Plaintiff.
Charles J. Butler, Ty Halasz, U.S. Department of Justice, Washington, DC, for Defendant.
ORDER
REGINA M. RODRIGUEZ, United States District Judge This case presents an issue of first impression on a question of the interplay between two different tax provisions: Rev. Proc. 92-29 and 26 U.S.C. § 103. Both parties have filed motions for summary judgment. For the reasons set forth herein, the Court GRANTS the Plaintiffs’ Motion for Summary Judgment and DENIES the Defendant's Motion for Summary Judgment .
This matter comes before the Court on the Parties’ Cross-Motions for Summary Judgment. The Plaintiffs filed their motion at ECF 41. The Defendant filed its cross-motion at ECF 44. Plaintiffs filed an opposition to the Defendant's cross-motion at ECF 46, and the Defendant filed its reply at ECF 48. At the Court's request, the Parties submitted additional briefing on the issue of burden of proof at ECF Nos. 64 and 65. Oral argument was held on October 21, 2021. The matter is now ripe for review.
The facts herein are drawn from the Parties’ briefing on the motions for summary judgment. The parties agree that the facts stated are not in dispute.
The Plaintiffs in this action are real estate developers ("Plaintiffs" or "Developers") who sought to develop parcels of land in unincorporated Weld County, Colorado. The Developers, through their s-corporations , sought to annex the unincorporated properties to the towns of Erie and Frederick, develop them, and sell the developed properties to homeowners. Developing the land required significant improvements to the existing infrastructure, including bringing water, sewer, other utilities and arterial roadways to the anticipated developments.
The Court notes that, unless otherwise stated, the Developers acted through their relevant s-corporation for each project. For convenience, the Court simply refers to the Plaintiffs and their entities as "Plaintiffs" or "Developers," collectively.
In light of the limits imposed by Colorado's Taxpayer Bill of Rights (TABOR), towns are generally unable to expend general tax dollars for infrastructure that would primarily benefit new development. Those seeking to develop new land must therefore provide the infrastructure themselves or must request that the relevant authorities allow them to establish special taxing districts to accomplish these tasks.
To construct the infrastructure in the Erie and Frederick properties, the Developers formed metropolitan districts ("Metro Districts"). The Metro Districts sought to pay for the necessary infrastructure through advances from Developers. The Developers invested a total of approximately $39 million for infrastructure in the various Metro Districts. In exchange for these payments, the Metro Districts issued the Developers bond anticipation notes ("BANs"). The Metro Districts intended to pay 8.5% interest on the BANs out of future property taxes levied on homeowners and businesses in the districts.
A. Developers’ Tax Return Reporting
1. Rev. Proc. 92-29 (The Alternative Cost Method)
The Developers elected to treat their development costs pursuant to the Alternative Cost Method, set out in Rev. Proc. 92-29, 1992-1 C.B. 748, 1992 WL 725618. Under the Alternative Cost Method, upon the sale of a portion of property, a developer is entitled to take an allocable share of the estimated expenses for common improvements in computing the costs of goods sold with respect to the sold property. Costs of common improvement may include funds advanced to third parties, such as the advances made to the Metro Districts here. The Developers thus included the advances to the Metro Districts as costs of construction for purposes of determining the costs of goods sold. There is no dispute that the Developers did not act improperly when using the Alternative Cost Method. See e.g. , Herzog Bldg. Corp. v. Commissioner , 44 T.C. 694, 699-702 (1965) (developer properly allocated to costs expenditures for purchasing municipal bonds to pay for development's sewage system).
2. Interest From Bond Anticipation
The Developers used the "accrual basis," which required them to take income into account when earned, not necessarily when received. Each year, the Developers treated the repayment of principal on the BANs as ordinary income; the Developers separately took the interest accruals on the BANs in each year into income as tax exempt pursuant to 26 U.S.C. § 103. Pursuant to section 103, gross income does not include interest on any state or local bond.
3. IRS Audit
The IRS audited the Developers’ tax returns for 2010 to 2013. The IRS determined that it was permissible for the Developers to have treated their investments as development costs pursuant to the Alternative Cost Method. However, the IRS found that, having done so, the Developers were foreclosed from treating the interest accruals on the BANs as tax exempt. The IRS thus assessed increases in tax liability for the Developers.
The Developers paid these amounts and now seek a refund of their payments.
II. QUESTION PRESENTED
The issue here focuses on the interplay between the Alternative Cost Method ( Rev. Proc. 92-29 ) and 26 U.S.C. § 103. The Court is specifically tasked with answering the following question: Can a taxpayer treat a debt instrument issued by a political subdivision as a cost of construction pursuant to Rev. Proc. 92-29 and also treat interest on the repayment of that debt instrument as tax exempt pursuant to 26 U.S.C. § 103 ?
III. APPLICABLE LAW
To succeed on a motion for summary judgment, the movant must demonstrate that (1) there is no genuine dispute of material fact; and (2) the movant is entitled to judgment as a matter of law. Fed. R. Civ. P. 56(a). When analyzing a motion for summary judgment, the court must "look at the factual record and the reasonable inferences to be drawn from the record in the light most favorable to the non-moving party." Self v. Crum , 439 F.3d 1227, 1230 (10th Cir. 2006). "[T]he fact that both parties have moved for summary judgment does not permit the entry of a summary judgment if disputes remain as to material facts." Harrison W. Corp. v. Gulf Oil Co. , 662 F.2d 690, 692 (10th Cir. 1981). However, "cross motions for summary judgment do authorize the court to assume that there is no evidence which needs to be considered other than that which has been filed by the parties." Renfro v. Emporia , 948 F.2d 1529, 1534 (10th Cir. 1991). Where the only issue before the Court is a pure question of law, summary judgment is proper. Sheline v. Dun & Bradstreet Corp. , 948 F.2d 174, 176 (5th Cir. 1991).
IV. BURDEN OF PROOF
The Developers here seek a refund of payments to the IRS. In tax refund suits, assessments or determinations by the IRS have the support of a presumption of correctness. United States v. Fior D'Italia, Inc. , 536 U.S. 238, 122 S. Ct. 2117, 2122, 153 L.Ed.2d 280 (2002). In an action to recover taxes paid to the IRS, the taxpayer has the burden to show that the IRS's assessment was erroneous. Alpenglow Botanicals, LLC v. United States , 894 F.3d 1187, 1198 (10th Cir. 2018) (citing Dye v. United States , 121 F.3d 1399, 1408 (10th Cir. 1997) ). A taxpayer must prove the claim to a refund by a preponderance of the evidence. 35 Am. Jur. 2d Federal Tax Enforcement § 921. If a taxpayer "introduces credible evidence with respect to any factual issue relevant to ascertaining the liability of the taxpayer" the burden shifts to the Government with respect to that factual issue. 26 U.S.C. § 7491(a)(1).
While the Parties here may dispute the implications of certain facts, both Parties agree that there are no facts in dispute. The burden is therefore on the Developers to establish that the IRS's assessment against them was erroneous.
V. ANALYSIS
The specific question before the Court is one of first impression, but the Court is guided by straightforward statutory analysis. Pursuant to 26 U.S.C. § 103, gross income does not include interest on any state or local bond. The term "state or local bond" is defined as "an obligation of a State or political subdivision thereof." Id. § 103(c)(1). The Supreme Court has instructed that the purpose of section 103 is "to aid the borrowing power" of government entities by making "interest-bearing bonds more attractive to investors." Helvering v. Stockholms Enskilda Bank , 293 U.S. 84, 87, 55 S.Ct. 50, 79 L.Ed. 211 (1934).
Neither Party here disputes that the interest paid on the bonds issued by the Metro Districts would ordinarily be tax-exempt and qualify for the section 103 exclusion. The United States instead argues that the Developers’ application of the Alternative Cost Method transformed the underlying transaction, such that the section 103 exemption can no longer apply.
The Parties’ arguments here are complicated and, at times, internally inconsistent. But an analysis of the governing tax principles reveals that the Court's inquiry here is, at its core, simply an application of the straightforward language of section 103. As set forth in further detail below, for the exemption in section 103 to apply, two requirements must be met: First, there must be an obligation of a State or local subdivision; and, second, there must be an agreement to pay interest on that obligation.
Both Parties conflate the obligation requirement with the interest requirement of section 103. In so doing, the parties ignore the plain language of the statute and the case law interpreting it. When analyzed in accordance with the statute's plain language, it becomes clear that the Developers’ application of section 103 to the interest accrued was appropriate because both requirements of section 103 were met. Nothing in Rev. Proc. 92-29, or the Developers’ application thereof, removed this transaction from the purview of section 103.
A. The Newlin Principle
The Parties appear to agree that an obligation need not be a traditional bond in order to trigger the section 103 tax exemption. The United States argues that, because of this agreement, the Newlin principle (set forth in Newlin Machinery Corp. v. Comm'r , 28 T.C. 837 (1957) ) is not relevant. According to the United States, notwithstanding Newlin , Plaintiffs’ use of the Alternative Cost Method, and the characterization of the advanced funds as costs of construction, transformed both the principal and interest on the bonds such that they ceased to be an obligation under section 103. But Newlin does not simply instruct that an obligation need not be a traditional bond to trigger the section 103 tax exemption; it also instructs that a political subdivision's obligation to a taxpayer and the interest on that obligation may be considered separately. The United States’ argument relies on a finding that the interest and the underlying obligation are inextricably intertwined, and the Developers’ tax treatment of its advances (the obligation) thus fundamentally alters the Metro District's agreement to pay interest on that obligation as well. Newlin and its progeny instruct otherwise.
In Newlin , the taxpayer sold machinery to a political subdivision under contracts that provided for installment payments of principal and interest. Notwithstanding that the underlying transaction did not involve a traditional debt instrument, the court ruled that the purchase orders were "obligations" pursuant to a predecessor to section 103 and any interest payable on those obligations was tax exempt. The Court explained that "Congress did not intend to limit the exemption for interest on obligations of a State subdivision to the interest on some particular form of obligation." Id. at 842. The Court in Marsh Monument Co. v. United States , 301 F. Supp. 1316, 1319 (E.D. Mich. 1969) echoed Newlin , explaining that "[t]he fact that interest was paid pursuant to a contract of sale, therefore, and not under a bond or other type of investment security would not prejudice plaintiff's right to exclude such sums from income." Marsh Monument and Newlin therefore instruct that the tax exemption in section 103 does not depend on any particular form of "obligation."
Newlin and Marsh Monument also suggest that, for purposes of section 103, the obligation itself differs from the promise to pay interest on that obligation. Both must be present for section 103 to apply. When analyzing the plaintiff's claim, the Marsh Monument court explained that "the 6% [interest] charge was the price for the right to defer payment for one year, and as such was a premium paid for forbearance from collecting an obligation, commonly known as ‘interest.’ " Id. at 1320. The court in Newlin likewise explained that "[t]he usual meaning ascribed to the word ‘interest’ is ‘the amount which one has contracted to pay for the use of borrowed money.’ " Newlin, 28 T.C. at 841. Thus, both Newlin and Marsh Monument suggest that an agreement to pay interest is separate from the underlying obligation from which the interest accrues. Indeed, the Supreme Court has considered the definition of the term "interest" and has opined that "the periodic payment universally called ‘interest’ is in part something wholly distinct; that is, a return of borrowed capital." Old Colony R. Co. v. Comm'r of Internal Revenue , 284 U.S. 552, 561, 52 S. Ct. 211, 76 L.Ed. 484 (1932). The plain language of section 103 supports this interpretation: gross income does not include the interest on any obligation of a state or political subdivision thereof. Section 103 thus presumes both an obligation and a separate commitment to pay interest on such obligation.
The obligation at issue in Newlin was an obligation to pay the purchase price for machinery, and the interest on that obligation was "paid for the use of borrowed money." Likewise, the obligation in Marsh Monument was an obligation to pay the purchase price for drain tile; the interest on that obligation was paid for "the right to defer payment for one year." Taking into consideration Newlin, Marsh Monument , and Old Colony , the obligation at issue in this case is an obligation to repay the bonds issued by the Metro Districts—that is, to repay the principal on the bonds. The interest on that obligation reflects a promise to pay 8.5% for the right to defer payment on the bonds to allow the Metro Districts to pay out of future property taxes. Thus, regardless of whether the underlying obligation is characterized as a bond, a purchase of goods, etc., the interest on that obligation is distinct and remains tax-exempt under section 103.
B. The Metro District's Obligation Was Not Changed By Developers’ Use of Rev. Proc. 92-29
The United States argues that, "having characterized the advances [to the metro districts] as costs, [Plaintiffs] could not then recharacterize the advances as loans or other debt instruments when the advances were repaid." ECF 44 p. 10. But the issue here is not the tax treatment of the repaid advances. The issue before this Court is the tax treatment of the interest paid on the advances.
Even accepting for argument's sake the United States’ argument that the Developers’ characterization of the advances as costs irrevocably transformed them, this would only serve to change the character of the underlying obligation. The interest on that obligation remains unchanged. The interest was not included as costs of construction for purposes of the Alternative Cost Method, and, indeed, was not paid until years later. Because the section 103 exemption is not limited to any particular form of obligation, this alleged recharacterization does not alter the section 103 analysis.
The Defendant's substance over form argument is thus misplaced—even if the substance of the transaction may have changed, such a change would, at most, impact the characterization of the Metro District's obligation. It would not alter its agreement to pay interest, and section 103 thus applies.
Indeed, the Defendant's position in this lawsuit undermines its claim that the interest paid on the BANs should be treated as anything other than interest. The IRS here audited tax years 2010 through 2013 and asserted that the interest accrued in those years is taxable. While the income was accrued in 2010-2013, it was not actually realized until 2019. If the accrued amounts are not interest, then it is unclear what would make them taxable in 2010-2013.
C. The Metro Districts Accepted the Advances Pursuant to Their Borrowing Power
The Defendant also argues that section 103 cannot apply because the Metro Districts did not accept the advances pursuant to their borrowing power. This argument, however, is unsupported and is at odds with the Defendant's own statements.
The Defendant relies on Con. Ed. v. U.S. , 10 F.3d 68 (2d Cir. 1993) to support this proposition. In Con. Ed. , the plaintiff agreed to prepay its taxes as a means of providing revenue for the city. In exchange for prepayment, the city provided a discount in the amount of the prime interest rate to account for the plaintiff's cost of borrowing funds. On its federal tax returns, the plaintiff excluded the prepayment discounts from calculation of its gross income as nontaxable interest on a government bond. The IRS, and the Second Circuit, found that this was improper. In so doing, the court "attach[ed] significant, and indeed controlling, weight to Con Edison's decision at the time of the transactions to avoid being a creditor." The court explained that the plaintiff "was loathe to enter into a debt transaction with the city, as evidenced by its refusal to purchase City-issued certificates of deposit." Id. at 71. The court also relied on an internal memorandum in which the plaintiff stated "that the prepayment constitute[d] a fully enforceable and valid payment of tax and not a loan." Id. at 72. Because the plaintiff carefully structured the transaction to avoid entering into a debt transaction, the court found, the "the City was not exercising its borrowing power in accepting Con Edison's tax prepayments, but instead was exercising its power to tax." Id.
Relying on Con. Ed. , the United States argues that the Metro Districts did not accept the advances pursuant to their borrowing power "because the substance of the transaction at issue was an expenditure of costs, and not a loan or other debt instrument," and therefore "tax-exempt interest under § 103 could not have accrued on repayments." ECF 44, p. 14. Con. Ed. , however, is distinguishable.
First, unlike in Con. Ed. , there is no dispute that, when the advances were made to the Metro Districts (and when the bonds were issued), the parties intended to enter into a debt transaction—the bonds themselves were debt instruments. The Court in Con. Ed. gave controlling weight to the fact that the plaintiffs had specifically structured the transaction to avoid entering into a debt relationship and instead purposefully structured the payment as a payment of taxes. Considering this structure, the court explained that "[m]unicipalities have the power to change the due dates of installments of property taxes in order to accelerate the municipalities’ cash flow ... Thus, when the City offered a prepayment discount in order to create an incentive for taxpayers to prepay property taxes, its actions were authorized under its taxing power, not its borrowing power." Con. Ed. , 10 F.3d at 72.
The United States asks the Court to find that the Metro Districts did not accept the advances pursuant to their borrowing power because the Developers did not treat the transaction as a loan when they included the advances as costs of construction. But the United States has already acknowledged that the Developers could have utilized section 103 if they had not chosen to use the Alternative Cost Method. The United States thus asks the Court to find that that the Metro Districts accepted the advances, when made , pursuant to their borrowing power, but that the Developers’ treatment of the transaction after the fact fundamentally changed the Metro District's acceptance. There is nothing in Con. Ed. or the other cited case law to support such a finding.
Adopting the United States’ position would also introduce significant uncertainty into the marketplace. Under the Defendant's proposed interpretation, whether a political subdivision exercised its borrowing power would be dependent on the lender's tax treatment of the arrangement. This would lead to considerable confusion. For example, the BANs given by the districts were negotiable instruments that could be sold to third parties. If the BANs were sold to a third party, that third party would have no way of determining whether or not the obligations had been issued pursuant to the Metro District's borrowing power and would thus be unable to determine whether the instrument was tax exempt. Further still, an analysis of the transaction at issue in Con. Ed. suggests that it does not meet the test set forth in Newlin and Marsh because there was neither a continuing obligation nor an agreement to pay interest. With regard to interest, the Second Circuit in Con. Ed. explained, "[t]he usual definition of interest is ‘the amount which one has contracted to pay for the use of borrowed money." Id. at 73 (citing to Old Colony , 52 S. Ct. at 214 ). "Since the prepayments constituted Con Edison's payment of its otherwise owed tax obligations, the discounts cannot accurately be characterized as ‘interest’ paid for the use of borrowed monies." Id. There thus was no agreement by the city to pay interest, and section 103 did not apply. Nor was there an underlying obligation because "[a]t the time of prepayment, both sides received full consideration and owed no future obligation—Con Edison for its tax liability, and the City for Con Edison's early payment." Id. Con. Ed. is therefore distinguishable and does not support the United States’ position here. The Court finds that the Metro Districts accepted the advances pursuant to their borrowing power.
The United States responds to this argument by explaining that "[i]f the plaintiffs had sold the BANs, then the buyer may well have received tax-exempt interest." ECF 48 p. 7. The United States’ argument thus requires the Court to find that whether a political subdivision exercised its borrowing power when issuing a debt instrument depends both on the lender's tax treatment of the arrangement and on who the current holder of that debt instrument may be. Such an argument is unsupported by any of the cited authority.
D. The Developers Did Not Receive Two Permanent Tax Benefits
The United States finally alleges that the Developers acted improperly because they took advantage of two different, permanent tax benefits: First, the Developers allegedly received a permanent tax benefit when they treated their advances to the Metro Districts as costs of construction. Second, the Developers received a permanent tax benefit when they took the interest accruals into income as tax-exempt. The United States’ argument, however, overstates the Developers’ tax benefits. While the Alternative Cost Method allowed the Developers to consider the funds invested as inventory costs ahead of time, the repayments of principal with respect to the amounts included in the cost pools and later deducted on the sale of property would be treated as reductions in costs of goods sold. Any tax benefit was therefore not permanent.
Further, the funds included in the cost pool for purposes of Rev. Proc. 92-29 are not the same funds implicated by the section 103 exemption. The funds included in the cost pool were the advances made to the Metro Districts. These advances did not include any interest.
Section 103, on the other hand, implicates only the interest payments due from the Metro Districts. This interest income was not a construction cost and was never treated as such. The interest income was consistently treated as interest. The Developers therefore did not receive two permanent tax benefits, nor did they receive benefits on the same funds.
E. The IRS Assessment Was Erroneous
The exemption in section 103 applies to the transaction here. The interest at issue in this case is interest on an obligation of a political subdivision and, as such, is tax-exempt. Neither the case law nor the general tax principles cited by the United States supports its argument that the Alternative Cost Method, set forth in Rev. Proc. 92-29, forecloses tax-exempt treatment under section 103. The IRS's assessment in this matter was thus erroneous.
VI. CONCLUSION
Because this Court finds that the IRS assessment was erroneous, the Plaintiffs’ motion for summary judgment is GRANTED . The Defendant's motion for summary judgment is DENIED.
As set forth in the Developers’ Motion for Summary Judgment, ECF 41 p. 9, n.2, this order will resolve the entire matter as to Plaintiffs Charles Bellock and Madeline Morrison. This action, however, was consolidated with David and Louise Gitlitz v. United States of America , 1:19-cv-01041-RM-GPG solely for the purpose of addressing issues involving 26 U.S.C. § 103. This order will not resolve all of the issues for the Gitlitz Plaintiffs.