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No. 96-1204
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EPCO, Inc. and Subsidiaries, *
*
Petitioner, *
* On Petition for Review
v. * of a Decision of the
* United States Tax Court.
*
Commissioner of Internal *
Revenue, *
*
Respondent. *
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Submitted: November 21, 1996
Filed: January 6, 1997
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Before RICHARD S. ARNOLD, Chief Judge, MAGILL, Circuit Judge, and SACHS,*
District Judge.
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RICHARD S. ARNOLD, Chief Judge.
Imperial Utility Corporation, a wholly owned subsidiary of EPCO,
Inc., together with Brooks McArthy, a developer, paid for the construction
of a sewer pipeline to service a tract of land owned by McArthy on which
he planned to develop a mobile home park. McArthy contributed $200,000 to
the construction of the sewer line, which is owned by Imperial. The
Commissioner of Internal Revenue found a deficiency in EPCO's 1989 federal
income tax based on Imperial's failure to report a portion of this
contribution as
*The Hon. Howard F. Sachs, United States District Judge for
the Western District of Missouri, sitting by designation.
gross income. (EPCO and its subsidiaries filed a consolidated return.)
EPCO then petitioned the Tax Court for a redetermination of the tax, and
the Tax Court upheld the Commissioner's determination. Upon EPCO's motion,
the Tax Court reconsidered its decision and again held for the
Commissioner. This appeal followed. We affirm the Tax Court on the main
substantive issue, whether McArthy's contribution resulted in income to
Imperial, but remand for further proceedings on the proper amount of that
income.
I.
In the mid-1980s, Brooks McArthy began to develop a mobile home park
upon a tract of land that he owned in Jefferson County, Missouri. To
provide sewage service to the property, as Missouri law requires, McArthy
had two feasible options.1 First, he could have constructed, at his own
expense, an on-site mechanical waste treatment facility. In the
alternative, he could have had the waste treated at a plant, owned by
Imperial, 2 1/2 miles north of the park. This option required the
construction of a mainline extension from the plant to the park as well as
the expansion of the plant to handle the additional sewage from the park.
McArthy consulted with Imperial on which option to choose.
Each option had its disadvantages. The on-site facility would have
been unsightly, somewhat noisy, and potentially malodorous. In addition,
the facility would have discharged the treated waste into a so-called
"losing stream," which is defined as one which loses at least 30 per cent.
of its flow into a groundwater system. As a result, "the discharge
effluent . . . would have emptied into
1
Another possibility - treating the waste in a three-to-five
acre on-site open-air lagoon using microbes to break down and
purify the waste - would have required McArthy to acquire
additional land, and McArthy abandoned this possibility without
inquiring into the possibility of purchasing land that was adjacent
to his property.
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a losing stream . . . at a point upstream from preschool playgrounds,
fishing lakes, homes, churches, and schools." Appellee Br. 4. Because of
this potential environmental hazard, the Missouri Department of Natural
Resources preferred the mainline sewer extension, though it would have
approved either method.
The primary disadvantage of the mainline-extension alternative was
its cost, which turned out to be more than three times the $150,000 cost
of the on-site facility. Imperial would have earned the same amount of
income ($18 per month per mobile-home pad) from the McArthy property
regardless of which method was chosen.2 Nevertheless, McArthy and Imperial
decided to build the sewer line and agreed to share the cost of
3
construction. McArthy placed $200,000 in an escrow account to be used to
finance the construction of the line, and the balance of the cost was to
come from Imperial. Withdrawals from the escrow required the signatures
of both McArthy and the president of Imperial, and owner of EPCO, Eugene
Fribis. According to the contract, the $200,000 contribution was to
replace "tap-on fees" that the Missouri Public Service Commission
authorized Imperial to charge the owners of mobile-home pads for connecting
their property to sewage service. Because the $200,000 was likely to
exceed the total of the authorized tap-on fees for the McArthy property,
McArthy and Fribis also agreed to credit any excess contribution to the
tap-on account of adjoining property owned by another corporation.4
The total project cost $540,000. Imperial spent about
2
Had McArthy chosen to build the on-site treatment facility,
EPCO would still have been responsible for operating the facility
and would have earned its monthly fee for this service.
3
Imperial's president testified that it would not have built
the sewer line without McArthy's agreement to pay for part of it.
4
McArthy eventually received $100,000 from this corporation.
Thus, the entire project cost McArthy only $100,000.
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$190,000 of its own money to expand the treatment capacity of its plant and
$150,000 of its own money to construct the sewer line. The remaining
contribution came from the escrowed funds which went to pay the general
contractor and subcontractors who built the sewer line. In 1988 Imperial
spent $164,375 of the $200,000 on the sewer line and reported the
contribution as income. EPCO also took a depreciation deduction on the
part of the sewer line that the contribution financed. In 1989, Imperial
spent the remainder of the $200,000 but did not report the $35,625 as
income and, consequently, also did not take the corresponding depreciation
deduction.
II.
The Internal Revenue Code allows corporations to exclude both
shareholder and nonshareholder contributions to capital from their gross
income. 26 U.S.C. § 118(a). Under the 1986 Tax Reform Act, "the term
`contribution to the capital of the taxpayer' does not include any
contribution in aid of construction or any other contribution as a customer
or potential customer." 26 U.S.C. § 118(b). The Report of the House Ways
and Means Committee explained that the provision's effect "is to require
that a utility report as an item of gross income the value of any property,
including money, that it receives to provide, or encourage . . . the
provision of, services to or for the benefit of the person transferring the
property." H.R. Rep. No. 99-426, 99th Cong., 1st Sess. 644 (1985). The
Tax Court found, and the Commissioner argues, that the $200,000 that
McArthy contributed to the building of the sewer line was a contribution
in aid of construction (CIAC) and that it thus constituted taxable income
that EPCO should have reported.
Two things are clear. McArthy was a customer of EPCO (or at the very
least was acting on behalf of potential customers of EPCO), and his
contribution aided in the construction of a line
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which was to provide sewer service to McArthy's development. EPCO,
however, seizes upon language in the Committee's Report that states that
transfers of property to utilities by members of a particular group will
normally be assumed "to encourage the provision of services . . . unless
it is clearly shown that the benefit of the public as a whole was the
primary motivating factor in the transfers."5
The "public benefit" exception, as well as the general exclusion for
contributions to capital, has its origin in a 1925 Supreme Court decision
which held that cash subsidies as well as land and buildings provided by
the government of Cuba to a railroad company to construct a railroad in
Cuba were not income within the meaning of the Sixteenth Amendment.6
Edwards v. Cuba R.R., 268 U.S. 628 (1925). The Court reached this
conclusion because it found that the payments "were not made for services
rendered or to be rendered" and were not "profits or gains from the use or
operation of the railroad." Id. at 633.
EPCO contends that McArthy's contributions to the sewer line
5
Ibid. Neither party argues that we should disregard this
exception because it does not appear in the statute itself. We
would disregard it anyway were it not for the history behind the
provision, which helps illuminate its meaning. The distinction
between contributions to capital made by customers to procure
service and contributions to achieve indirect benefits to the
public at large was a familiar one in judicial decisions that
preceded passage of 26 U.S.C. § 118 in 1954, and it is universally
recognized that this statute was no more than a codification of
judicial decisions up to that point. The post-passage preservation
of the distinction is evident from such cases as Teleservice Co. of
Wyoming Valley v. Commissioner, 254 F.2d 105 (3d Cir.), cert.
denied, 357 U.S. 919 (1958), and its preservation in 26 U.S.C.
§ 118(b) is evident from the fact that 118(b) exempts only customer
contributions in aid of construction from the exclusion for
contributions to capital.
6
EPCO does not argue in this Court that the contribution in
question was not income within the meaning of the Sixteenth
Amendment. Its argument is based solely on the statute.
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were not made to encourage service to McArthy's property, but instead to
benefit the public. McArthy would have gotten sewage treatment for his
property regardless of the method chosen. He chose what was, both for him
and EPCO, the far more expensive method of sewage treatment only because
the alternative would have led to more water pollution. While EPCO
obviously cannot deny that the sewage line provides its customer with
sewage service, EPCO contends that McArthy's choice of the more expensive
method was for the public's benefit.
We believe that the relevant inquiry is into McArthy's motivation for
choosing one sewage treatment method over another. The record does not
convince us that McArthy's primary motivation was an altruistic concern for
the environment beyond his own development. The Tax Court found that the
on-site treatment facility "would have been noisy and unsightly and would
have emitted unpleasant odors, which would have detrimentally affected
property values. . . . [and therefore] that McArthy chose the main- line
extension because it best suited his purposes in providing sewer service
to [his development]." EPCO, Inc., T.C. Memo. 1995-249, slip op. at 22-23.
Thus, the Tax Court found that McArthy chose the sewer line method because
of its direct benefit to McArthy's property and, consequently, the future
occupants of his development.
We review this finding of fact only to determine whether it was
clearly erroneous. We hold that it is not unreasonable to think that a
developer seeking sewage service for his property would pay an extra
$50,000 to avoid having a smelly sewage facility on the property itself,
and that there was evidence to support the Tax Court's conclusion that this
was, in fact, Mr. McArthy's primary motivation. This conclusion is
reinforced by the provision in the contract that states that the $200,000
contribution was to be in lieu of fees that EPCO could have charged mobile
home owners to connect their property to sewage service. Add to this
evidence
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the natural assumption that a developer acts to maximize his profit and not
the general welfare, and it becomes clear that McArthy was acting as a
customer of EPCO and not a public citizen when he made his contribution.
Accordingly, we hold that McArthy's contribution to the construction of the
sewer line was a taxable contribution in aid of construction under 26
U.S.C. § 118.
III.
The question of how to value what EPCO got, and thus how much to
include in its income, remains. The Tax Court held that $35,625 was
includible in income for the year 1989 - the full amount of money paid from
the escrow account that year to contractors and subcontractors working on
the sewer line. These payments went to defray debts for which EPCO was
liable. (McArthy was liable for them, too, but that does not change the
essential point.) In general, a payment made to pay someone's debt is
income to that person. E.g., Old Colony Trust Co. v. Commissioner, 279
U.S. 716 (1929).
EPCO replies that this general rule does not apply where, as here,
the debt paid was itself created as part of the same transaction that
included the payment. Imperial would not have built the sewer line, and
thus would not have contracted the $200,000 in obligations that were paid
out of the escrow account, if McArthy had not agreed to contribute the
$200,000 in the first place. EPCO says that what it actually received was
not money or the liquidation of debts, but the sewer line, which Imperial
ended up owning. The value of the line, EPCO adds, was not the $540,000
cost incurred ($340,000 from Imperial and $200,000 from McArthy), but the
present value of the stream of future income expected to be realized from
customers tapping on to the sewer line - an amount EPCO fixes at about
$360,000. This would reduce the total amount of McArthy's contribution to
EPCO's (or Imperial's) capital from $200,000 to about $20,000 (the $360,000
value of the line less the
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$340,000 paid by Imperial).
We agree with EPCO that the debt payments themselves were not ipso
facto income to it. See Fox v. Harrison, 145 F.2d 521 (7th Cir. 1944)
(payment of debt not income when debt incurred as part of same transaction
that envisioned the payment). We further agree that what EPCO got out of
this transaction was the sewer line. But the question of the value of the
sewer line is one of fact, and the Tax Court, the finder of fact, never
reached that question, having stopped its analysis with the conclusion that
what EPCO got was payment of its debts. The income expected to be produced
by the line from McArthy's mobile-home park is certainly one possible
criterion of that value. But it is not the only possible criterion. Also
relevant is the fact that $540,000 was paid for the line. We have
difficulty believing that businesspeople would pay $540,000 for an asset
that, immediately upon purchase, became worth only $360,000. The
difference may be due, at least in part, to the possibility that other
users might tap on to the line in the future - for example, users on the
adjoining property, whose owners contributed half of the $200,000.
This issue of fact needs to be explored further in the court of first
instance, the Tax Court.
We agree with the Tax Court that McArthy made a contribution in aid
of construction to Imperial that should have been included in Imperial's
gross income. We do not agree with that Court's holding as to the value
of that contribution. The judgment of the Tax Court is vacated, and the
cause remanded for further proceedings as to valuation not inconsistent
with this opinion. The Tax Court may in its discretion allow either party
to introduce additional evidence.
It is so ordered.
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A true copy.
Attest:
CLERK, U.S. COURT OF APPEALS, EIGHTH CIRCUIT.
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