King v. Comm'r of Internal Revenue

• Decision Date: 17 November 1981
• Docket Number: Docket No. 1273-79.
• Citation: 77 T.C. 1113
• Parties: J. ROBERT KING, JR., and VIRGINIA S. KING, PETITIONERS v. COMMISSIONER of INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

77 T.C. 1113

J. ROBERT KING, JR., and VIRGINIA S. KING, PETITIONERS

v.COMMISSIONER of INTERNAL REVENUE, RESPONDENT

Docket No. 1273-79.

United States Tax Court

Filed November 17, 1981.

Held, the interest received on warrants obtained as part of the consideration for land sold to the Trinity River Authority under a threat of condemnation is not excludable from gross income under sec. 103(a)(1), I.R.C. 1954. Drew v. United States, 551 F.2d 85 (5th Cir. 1977), followed. Held, further, interest received on warrants obtained as part of the consideration for land sold to the Trinity River Authority in a voluntary transaction is excludable from gross income under sec. 103(a)(1), I.R.C. 1954. Glenn A. Rosenbaum, John G. Heard, and Thomas P. Marinis, Jr., for the petitioners.

Evelyn B. Brennan and William D. Peltz, for the respondent.

FEATHERSTON , Judge:

Respondent determined the following deficiencies in petitioners' Federal income taxes:

+----------------+
                ¦Year  ¦Amount   ¦
                +------+---------¦
                ¦      ¦         ¦
                +------+---------¦
                ¦1971  ¦$17,492  ¦
                +------+---------¦
                ¦1972  ¦4,941    ¦
                +------+---------¦
                ¦1973  ¦7,791    ¦
                +------+---------¦
                ¦1974  ¦4,108    ¦
                +----------------+
                

The issue for decision is whether the interest, or any portion thereof, received by petitioner Virginia S. King on warrants issued to her by the Trinity River Authority is excludable from income for the years in controversy under section 103(a)(1).¹

FINDINGS OF FACT²

Petitioners J. Robert King, Jr., and Virginia S. King, husband and wife, were legal residents of Texas when they filed their petition. They filed their joint Federal income tax returns for 1971, 1972, 1973, and 1974 with the District Director of Internal Revenue, Austin, Tex. J. Robert King, Jr., is a petitioner only because of his community interest in the income in question and his filing joint returns with his wife. Accordingly, Virginia S. King will hereinafter be referred to as petitioner.

Prior to May 29, 1969, petitioner owned an undivided one-fourth interest in 4,928.35 acres of land known as the Smither Farm. Petitioner's interest, together with the interests of the other coowners, was managed by E. M. Smither Co., a partnership. On or about October 29, 1968, the E. M. Smither Co. received a letter from the Trinity River Authority of Texas (TRA) making an offer to purchase the Smither Farm for $1,861,471. The letter stated that TRA's Lake Livingston reservoir project would require 21.94 acres in fee simple and a flowage easement of 2,309.52 acres.³ The letter further stated that “it has been suggested that we attempt to acquire the 4,928.35 acres of land in its entirety” to solve a problem with respect to land for the Ellis Prison Unit of the Texas Department of Corrections.

TRA, a political subdivision of the State of Texas, is charged with developing the soil and water resources of the Trinity River watershed in east Texas. One of its projects was the construction of Lake Livingston, a reservoir intended primarily to supply water to the City of Houston, Tex. The project was financed by a bond issue of $50 million. Part of these funds were later used for the purchase of land within the lake site.

Consistent with the letter of October 29, 1968, the purpose of the acquisition of the Smither Farm by TRA was twofold: (1) TRA's Lake Livingston construction project required the acquisition of 22.14 acres in fee simple for reservoir purposes and 2,316.03 acres in flowage easements; (2) the remaining 2,590.18 acres were needed to provide TRA with land suitable for trade to the Texas Department of Corrections for lands in the Ellis Prison Unit which were to be subjected to flooding as a result of the construction of Lake Livingston.

TRA had the power of eminent domain with respect to the 22.14 acres required for reservoir purposes and with respect to the flowage easement over the 2,316.03 acres.⁴ TRA did not have the power of eminent domain over the remaining 2,590.18 acres of land to be traded to the Texas Department of Corrections or the fee interest in the 2,316.03 acres of land to be covered by a flowage easement. Had petitioner and the other coowners of the Smither Farm refused to accept TRA's offer of October 29, 1968, TRA would have restricted its purchase to that portion of the Smither Farm that was subject to TRA's power of eminent domain—-that is, 22.14 acres of land and a flowage easement over 2,316.03 acres of land.

On or about May 29, 1969, petitioner and the other coowners, after oral negotiations, agreed to sell the Smither Farm to TRA for a consideration of $2,112,048.70. The consideration was to be composed of cash in the amount of $122,048.70 and warrants issued by TRA in the total amount of $1,990,000 bearing interest at the rate of 6.5 percent per annum. Petitioner's share of the cash was $33,637.19; her share of the warrants was $490,000, consisting of one warrant for $90,000 and four warrants for $100,000 each. Petitioner designated the combination of cash and warrants she was to receive as well as the payment schedule for the warrants. In her income tax returns, petitioner reported her gain on the sale of her land on the installment basis provided by section 453.

The warrants were issued pursuant to a resolution passed by TRA's executive committee on September 27, 1966, and approved by TRA's board of directors on October 21, 1966. That resolution authorized the Livingston Project Administration Committee to negotiate for the purchase of land on terms calling for payment of a portion of the price in cash and the delivery of negotiable interest-bearing warrants for the balance. Immediately upon issuance of a warrant, TRA was to deposit a sum of money equal to the face amount of the warrant in a special account (hereinafter sometimes referred to as the Southwest account) with the First Southwest Co. of Dallas, Tex., styled “First Southwest Company, agent, Trinity River Authority of Texas (Livingston Project) Land Acquisition Escrow Account.” Interest earned on the account was to be used to pay the interest on the warrants and the cost of administering the fund, and the balance was to be returned to TRA. Other than the resolution, no written agreements governing the rights of the parties were executed by them with respect to the account.

In an opinion dated January 9, 1967, prepared by counsel for TRA and addressed to the project manager of TRA, the following statement is made concerning the effect of the resolution:

As I understand the Resolution, the Escrow Agreement and the Deferred Certificates, the First Southwest Company is acting as agent for the Trinity River Authority in investing funds set aside to make the deferred payments and in servicing the outstanding warrants. However, the Trinity River Authority is primarily liable for payment of the certificates issued to the landowner even in case of default by the First Southwest Company.

The funds in the escrow account of the agent are the legal property of the Trinity River Authority, as principal, until paid out by the agent at the maturities of the certificates.

An opinion dated January 22, 1968, prepared by counsel for TRA and addressed to the project manager, contains the following statement regarding the nature of the obligations created by the warrants:

III.

Are the warrants issued by the Trinity

River Authority obligations of the

Trinity River Authority?

Warrants issued by the Trinity River Authority in its program of land acquisitions for the Lake Livingston Project are special, secured obligations of the Trinity River Authority. The resolution of the Board relating to the purchase of land by warrants requires that “immediately upon execution and delivery of any warrant under the provisions of this resolution the administrative committee shall cause to be transferred an amount of money equal to the face amount of such warrant to a special account with the First Southwest Company of Dallas, Texas, styled ‘First Southwest Company, agent, Trinity River Authority of Texas (Livingston Project) Land Acquisition Escrow Account.’ ” The form of warrant recommended herein above would show on its face that it is a special obligation—-payable out of a particular fund. The terms of the resolution require that the warrants be secured by deposit to the fund “immediately” after delivery of any warrant.

Amounts deposited in the Southwest account by TRA were listed as assets on its financial statements. Correspondingly, unpaid and outstanding warrants were listed on TRA's financial statements as liabilities.

The issuance of the warrants permitted the landowners to report their gains from sales to TRA on the installment basis under section 453. TRA's purposes in issuing the warrants, as conceived by its management, were to facilitate the land acquisition through increased flexibility in negotiations with the landowners, thereby reducing the cost of land acquisition, and to earn interest on the money through investment of funds in the Southwest account.

During 1971, 1972, 1973, and 1974, petitioner received $33,692, $9,750, $13,686, and $6,500, respectively, from TRA as interest on the warrants outstanding during each of those years, and petitioners excluded the interest from gross income for Federal income tax purposes. Respondent determined that the warrants do not qualify as obligations for which interest is excludable under section 103, and he increased petitioners' taxable income accordingly.

OPINION

Petitioner contends that the interest which she received on the warrants issued by TRA as part of the consideration for the purchase of her land is exempt from Federal income taxes as interest on “obligations” of a “political subdivision” of Texas within the meaning of section 103(a)(1). Respondent contends that the warrants were not issued by TRA in the exercise of its borrowing power, but as a method of making payment for the land from funds already borrowed, and that, therefore, the...