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Tax-Exempt Bonds: The Third Circuit Court of Appeals held, in IRS v. DeNaples, that Internal Revenue Code Section 103 provided an exemption from federal income tax to interest payments paid under an installment agreement by the State to Taxpayers.
Taxpayers Dominick and Louis DeNaples were both partners in several entities that owned an interest in parcels of real property in Pennsylvania. The land was acquired by the State to build the Lackawana Valley Industrial Highway through condemnation and in 2001, the Taxpayers entered into an agreement whereby the state would pay them $40.9 million ($24.6 million in principal and $16.3 million in "settlement" interest) in exchange for the ownership interest in the land.
The parties agreed that the money would be paid in five installment payments. With the installment payments, the parties agreed to interest payments on the installment payments. When filing taxes for the years 2003-2005, Taxpayers excluded a portion of the settlement interest and all of the installment interest.
While the 3rd Circuit addressed both types of interest, the more substantive argument was based around the installment interest and whether this interest arose from an obligation of the State.
Interest would be excludable from income if it came under the borrowing power of the State. Under Section 103 of the IRC, "gross income does not include interest on an State or local bond." The Code further defines "State or local bond" as "an obligation of a State or political subdivision thereof." To go one step further, the courts have defined "obligation of a State" to include that which arises under the State's borrowing power.
The 3rd Circuit noted that when a state pays interest at a fixed rate pursuant to a statutory or judicial command, it's taxable. Now, if the obligation to pay interest arises from voluntary bargaining, there is an implication of the State's borrowing power and the interest is not taxable under Section 103.
While this summary covers the birds' eye view of the case, the reality is that Section 103 and the area of tax-exempt bonds are very complex tax concepts, even for most tax attorneys. The related resources below provide some further clarification on tax-exempt bonds.