Nontaxable "contribution" or taxable "fee"?

The receipt of a fee gives rise to taxable income. By contrast, receipt by a corporation of a "contribution to capital," even from a nonshareholder, does not give rise to taxable income, except in the case of a "contribution in aid of construction" or of a contribution from a customer or potential customer. The lines between the three categories -- taxable fees, taxable contributions and nontaxable contributions -- are a bit hazy at times, and it is not unknown for corporate taxpayers to try to push a questionable receipt into the nontaxable column. A recent attempt to do so was turned back by the Tax Court. Epco Inc. v. Commissioner (June 12, 1995).

Epco, a public utility engaged in the business of sewage collection and treatment, was approached by Brooks McArthy to provide sewer service at the Brookshire Village Mobile Home Park in Missouri. The Missouri Department of Natural Resources ("DNR") would have permitted use of any of three methods for dealing with wastewater and sewage -- an on-site lagoon, an on-site sewage plant or a "main-line extension" of an existing underground sewage pipe running to a centralized plant. Under the tariff approved by DNR, Epco would receive a one-time "contribution in aid of construction fee" of $400 to be paid by the customer for each mobile home at Brookshire. The main-line extension method, which was preferred for environmental reasons and also allowed for the potential of a limited amount of additional revenue if additional customers could be found to use the extension, was ultimately selected by Epco.

The total cost to Epco of providing sewer service to Brookshire came to $540,000. (By comparison, each of the other two methods would have cost approximately $150,000.) The contract between Epco and McArthy called for McArthy to pay $200,000 in "tap-on fees," a term often used in the industry interchangeably with "contributions in aid of construction." McArthy's payment of this amount during 1988 and 1989 also entitled the project to a dollar-for-dollar credit against the $400 per mobile home "contribution in aid of construction fee." Since there were fewer than 500 mobile homes at Brookshire, it appears that none of the "contributions in aid of construction" were actually paid. Ultimately, the Brookshire development was not very successful, and Epco realized less than $15,000 of revenues from the Brookshire residents and under $4,000 from other users of the main-line extension in each year through 1994.

Epco excluded from its income a portion of the amounts that it received from McArthy on the theory that they were "contributions to capital" which were not, notwithstanding the terminology used by the parties' contract and the DNR tariff, "contributions in aid of construction." The Tax Court agreed with the Internal Revenue Service that Epco was taxable on all the amounts received.

The tax law was not always so harsh to the recipients of contributions in aid of construction. In fact, from 1976 to 1986, such contributions to regulated public utilities were by statute specifically treated as nontaxable contributions to capital, even though in many ways they were more like prepaid fees for utility services. With the Tax Reform Act of 1986, Congress changed all that. Prior to the 1986 Act, contributions in aid of construction were nontaxable regardless of whether they qualified as contributions to capital; after the 1986 Act, contributions in aid of construction became taxable, even if they qualified as contributions to capital.

The court found it easy to conclude that the amounts received by Epco from McArthy were taxable as contributions in aid of construction. First, those amounts were credited against amounts that otherwise would have been paid by Epco's customers. Second, McArthy was motivated to make the payments by a potential direct benefit to himself, i.e., to obtain sewer service for property that he was developing. Moreover, since the sewer extension generated little income and had a value to Epco less than its cost, it appeared that the payments were more in the nature of compensating Epco for its expenses and providing an incentive to incur them, than in the nature of conferring an affirmative benefit on Epco. The court's analysis of this question seems at points to confuse the factors which pre-1986 cases found significant in distinguishing contributions to capital (whether or not in aid of construction) from taxable fees and those which are relevant in distinguishing contributions in aid of constructions from other sorts of contributions to capital. However, the conclusion it reached on this issue in Epco's case seems quite clearly correct.

Epco also argued that the legislative history of the 1986 Act indicated that, where the primary motivating factor in the making of a contribution is "benefit to the public as a whole," the contribution should not be treated as a contribution in aid of construction. The court rejected this argument. Since McArthy was motivated in choosing the main-line extension not by concern for the environment, but by the effect that "noisy and unsightly" on-site facilities would have on property values at Brookshire, it was the benefit to McArthy himself and not that to the public at large which motivated his contribution to Epco.

This was an easy case for the Internal Revenue Service. However, it does serve as a reminder of the potential existence of more favorable rules when the facts can be better developed and the parties' documents do not point so clearly to a customer-based relationship. As always, careful attention to detail throughout the deal-making and contract-drafting processes can make a big difference.

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