Indianapolis Power & Light Co. v. C.I.R., 87-2438

• Decision Date: 20 September 1988
• Docket Number: No. 87-2438,87-2438
• Citation: 857 F.2d 1162
• Parties: -5708, 88-2 USTC P 9529, 98 P.U.R.4th 535 INDIANAPOLIS POWER & LIGHT COMPANY, Appellee, v. COMMISSIONER OF INTERNAL REVENUE, Appellant.
• Court: U.S. Court of Appeals — Seventh Circuit

Page 1162

857 F.2d 1162

62 A.F.T.R.2d 88-5708, 88-2 USTC P 9529,

98 P.U.R.4th 535

INDIANAPOLIS POWER & LIGHT COMPANY, Appellee, v. COMMISSIONER OF INTERNAL REVENUE, Appellant.

No. 87-2438.

United States Court of Appeals, Seventh Circuit.

Argued Feb. 19, 1988.

Decided Sept. 20, 1988.

William A. Whitledge, Michael L. Paup, Chief, Appellate Section, Tax Div., Dept. of Justice, Washington, D.C., for appellant.

Larry J. Stroble, Barnes & Thornburg, Indianapolis, Ind., for appellee.

Before BAUER, Chief Judge, and FLAUM, and KANNE, Circuit Judges.

FLAUM, Circuit Judge.

The Internal Revenue Service ("IRS") assessed deficiencies against Indianapolis Power & Light Company ("IPL") for the tax years 1974-77, arguing that deposits IPL required certain customers to make in order to receive electrical services were advance payments for tax purposes that should have been included in gross income in the year IPL received them. IPL contested the deficiencies. The Tax Court ruled that the sums were security deposits and that IPL therefore properly excluded them from gross income. We affirm. ¹

I.

IPL generates and sells electricity in Indianapolis and neighboring areas of Indiana. It is an Indiana public utility and is therefore subject to the Rules and Regulations of Service for Electrical Utilities in Indiana ("the Rules of Service") promulgated by the Public Service Commission of Indiana ("PSCI"). During the years in question, approximately 5% of IPL's customers were required under the Rules of Service to make deposits. The receipts issued to these customers stated in part that the deposits were "to insure prompt payment" for the electrical service IPL was to provide. ² The customers to whom this requirement applied were identified by a credit test. If a customer who was initially required to make a deposit later demonstrated creditworthiness, the deposit was refunded.

The specific rules governing the administration of this deposit program were amended on March 10, 1976. Prior to this amendment, IPL administered the deposit requirement on a case-by-case basis. A credit test was employed, but there were no fixed financial rules for making the creditworthiness determination. Once a customer was required to make a deposit, the customer could only obtain a refund by specifically requesting a review and then affirmatively demonstrating his or her creditworthiness. The amount of the deposit was equal to twice the customer's estimated monthly bill and IPL paid interest at an annual rate of 3% on sums held at least six months. The interest was paid at the time the deposit was refunded or alternatively, if the customer requested, annually. The manner of the refund, either by cash, check, or an offset against the customer's electric bill, was determined by the customer.

The 1976 amendments were largely designed to minimize the arbitrariness that was perceived to exist under the prior rules. Under the revised rules, IPL was required to evaluate the creditworthiness of all new residential applicants and existing residential customers. IPL required deposits from those new customers who failed the credit test furnished by PSCI and also from existing customers who had a history of late payment. Commercial customers continued to be evaluated on a case-by-case basis.

Under the amended rules, IPL refunded a customer's deposit if the customer paid his or her electric bill on a timely basis for nine straight months or for ten out of twelve months (as long as the two delinquent months were not consecutive). Alternatively, the customer could obtain a refund by later satisfying the credit test. Deposits refunded on either of these two grounds were made in cash or by check, unless the customer requested that the amount of the deposit be offset against his or her bill. On the other hand, refunds resulting from the termination of service were generally made by offsetting the deposit amount against the customer's final electric bill, unless the customer specifically requested otherwise. Customers whose deposits were held by IPL for at least 12 months were paid interest at 6% annually. Information about the deposit requirement and corresponding refunds was set forth in a pamphlet which IPL was required to provide to its customers.

The customer deposits IPL received were not segregated from its other assets in any manner, but rather IPL used them in the ordinary course of its business. IPL was an accrual basis taxpayer for the years in question and treated the deposits as current liabilities at the time they were received. ³ If the deposit was later used to offset a customer's bill, IPL made the necessary accounting adjustments at that time. Unclaimed deposits escheated to the state.

II.

A.

The issue raised by this appeal is whether IPL should have included the customer deposits in gross income in the year of receipt (with a corresponding loss when refunded) rather than recording them as a current liability. ⁴ This in turn hinges on the legal standard a court should utilize when evaluating the taxability of customer deposits. The IRS argues that the proper test for determining the tax consequences of these types of deposits is set forth in City Gas Co. of Florida v. Commissioner, 689 F.2d 943 (11th Cir.1982).

The facts in City Gas are very similar to those in the present case. New customers of the City Gas Company and two of its subsidiaries were required to make deposits to secure the payment of all bills for service rendered to them. All three of the companies mingled the deposits they received with their other corporate funds. City Gas, but not its two subsidiaries, paid interest to its customers on their deposits at 4% annually. When a customer discontinued service the companies refunded the deposit by either crediting the amount against the customer's final bill or by sending the customer a check.

The Tax Court in City Gas ruled that these customer deposits were not taxable when received by the three companies. The Eleventh Circuit reversed, ruling that the proper test is to look at the primary purpose of the deposit. If its primary purpose is to secure the future payment for goods or services to be provided by the deposit recipient, then it is taxable upon receipt in the same manner as an advance payment of income. City Gas, 689 F.2d at 946, 948 n. 7. On the other hand, if the deposit is designed to cover any damage to property in the possession of the depositor, but owned by the deposit recipient, or to secure the performance of other non-income provisions of a contract ("non-income covenants"), it is not considered an advance payment. Id. Because it is undisputed that the purpose of the deposits received by IPL was to secure the payment of their customer's electric bill, an income item, the IRS asserts that IPL should have included the deposits in gross income when it received them.

A unanimous Tax Court declined to apply the Eleventh Circuit's City Gas test in this case. Indianapolis Power & Light Co. v. Commissioner, 88 T.C. 964 (1987). Rather, the Tax Court adhered to its own prior decision in City Gas and held that the proper approach is to determine whether in the facts and circumstances of the case, the customer deposit serves as an advance payment of income or as security for future performance. ⁵ In the Tax Court's view, this determination is made by comparing the rights retained by the depositor with the rights acquired by the depositee. If the deposit is to serve as security, it is properly excluded from income, regardless of whether the future performance it secures is the payment of income for services to customers or merely non-income covenants such as protecting against damage to property.

Employing this test, the Tax Court ruled that the customer deposits held by IPL were properly excluded from IPL's gross income. The Tax Court primarily relied on three factors. First, only five percent of the customers were required to make deposits. The Tax Court reasoned that if the deposits were really intended to serve as an advance payment, IPL would have required such deposits from all of its customers. Second, although IPL had discretion as to how to use the deposits it held, the customers controlled the timing and the disposition of the deposit. Prior to 1976 a customer could request a reevaluation of his or her creditworthiness and after 1976 a customer's timely payment of his or her bill for nine consecutive months led to an automatic refund. IPL paid between 30% and 40% of its refunds by check; it handled the remainder by offsetting the deposit amount against the customer's bill. Third, IPL paid interest on the deposits.

The proper legal test for a court to apply in determining the appropriate tax treatment of deposits such as those received by IPL is a question of law which we review de novo. IPL's intentions and purposes in requiring customers to make these deposits, however, are questions of fact which we review under a clearly erroneous standard. Busch v. Commissioner, 728 F.2d 945 (7th Cir.1984).

B.

We begin with the two baseline rules with which both parties agree. First, a deposit given to secure a non-income covenant is non-taxable to the deposit recipient. Gross income is defined to include all income from whatever source. 26 U.S.C. Sec. 61. A deposit to secure tangible property, however, is not considered income because it is offset by an obligation to refund the deposit if the property being used by the depositor is returned to the deposit recipient undamaged. Frequently the deposit recipient has unrestricted use of the deposit during this time period. Despite this discretion, the deposit recipient is not required to include the deposit in gross income because he or she is not considered to have "gained" for tax purposes. Clinton Hotel Realty Corp. v. Commissioner, 128 F.2d 968, 969 (5th Cir.1942); J. & E. Enterprises, Inc. v. Commissioner, 26 T.C.M. 944, 946 (1967). See also Illinois Power Co. v....