### *Th e Hon. Howard F. Sachs, United States District Judge fo r

the Western District of Missouri, sitting by designation. _____________ No. 96-1204

_____________ EPCO, Inc. and Subsidiaries, * * Petitioner, * * On Petition for Review v. * of a Decision of the * United States Tax Court. * Commissioner of Internal * Revenue, * * Respondent. *

___________ Submitted: November 21, 1996 Filed: January 6, 1997

___________ Before RIC HARD S. ARNOLD, Chief Judge, MAGILL, Circuit Judge, and SACHS, * District Judge.

___________ 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. McArt hy contributed $200,000 to the co nstruction of the sewer line, which is owned by Imperial. Th e Commissioner of Internal Revenue found a deficie ncy in EPCO's 1989 federal inc ome tax based on Imperial's failure to report a portion of thi s contribution as

### Another possibility - treating the waste in a three-to-five 1 

### acr e on-site open-air lagoon using microbes to break down an d purify the waste - would have required McArthy to acquir e addi tional land, and McArthy abandoned this possibility withou t inquiring into the possibility of purchasing land that was a djacent to his property.
-2- gro ss 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 Ta x Court reconsidered its decision and again held for th e Commissioner. This a ppeal followed. We affirm the Tax Court on the main substantive issue, whether McArthy's contribution resulted in income t o Imperial, but remand for further proceedings on the proper amount of that income.

I.
In the mid-1980s, Brooks McArthy beg an to develop a mobile home park upon a tr act of land that he owned in Jefferson County, Missouri. T o provide sewage servic e to the property, as Missouri law requires, McArthy had t wo feasible options. First, he could have constructed, at his ow n 1 expens e, an on-site mechanical waste treatment facility. In th e alt ernative, he could have had the waste treated at a plant, owned b y Imperial, 2 1/2 miles north of the park. This option required th e construction of a mainline extension from the pl ant 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 opti on had its disadvantages. The on-site facility would have been unsightly, somew hat noisy, and potentially malodorous. In addition, the fac ility would have discharged the treated waste into a so-calle d "losing stream," which is defined as one which l oses at least 30 per cent. of its fl ow into a groundwater system. As a result, "the discharg e effluent . . . would have emptied into

### Had McArthy chosen to build the on-site treatment facility, 2 

### EPCO would still have been responsible for operating the facility and would have earned its monthly fee for this service. Imperial's president testified that it would not have built 3 

### the sewer line without McArthy's agreement to pay for part of it. McArthy eventually received $100,000 from this corporation

. 4 

### Thus, the entire project cost McArthy only $100,000.
-3- a l osing stream . . . at a point upstream from preschool playgrounds , fishing lakes, homes, churches, and schools." A ppellee Br. 4. Because of this potential environmental hazard, the Missouri Department of Natura l Resour ces preferred the mainline sewer extension, though it would hav e approved either method.

The primary disadvantage of the mainline-extension alternative wa s 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 o f inco me ($18 per month per mobile-home pad) from the McArthy propert y regardless of which method was chosen. Nevertheless, McArthy and Imperial 2 decided t o build the sewer line and agreed to share the cost o f construction. McArthy placed $200, 000 in an escrow account to be used to 3 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 Frib is. According to the contract, the $200,000 contribution was t o rep lace "tap-on fees" that the Missouri Public Service Commissio n authorized Imperial to charge the owners of mobile-home pads for connectin g their prop erty to sewage service. Because the $200,000 was likely t o exceed the total of the authorized tap-on fees for the McArthy property, McArthyand Fribis also agreed to credit any excess contribution to th e tap-on account of adjoining property owned by another corporation. 4
The total project cost $540,000. Imperial spent about

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$190,000 of its own money to expand the treatment capacity of its plant an d $15 0,000 of its own money to construct the sewer line. The remainin g contribution came from the escrowed funds which went to pay the genera l contractor and subcon tractors who built the sewer line. In 1988 Imperial spent $1 64,375 of the $200,000 on the sewer line and reported th e contribution as income. EPCO also took a depreciation deduction on th e part of the sewer lin e that the contribution financed. In 1989, Imperial spe nt the remainder of the $200,000 but did not report the $35,625 a s income and, consequently, also did not take the corresponding depreciation deduction.

II.

The Internal Revenue Code allows corporations to exclude bot h shareholder and nonshareholder contributions to capital from their gross inco me. 26 U.S.C. § 118(a). Under the 1986 Tax Reform Act, "the ter m `contrib ution to the capital of the taxpayer' does not include an y contribution in aid of construction or any other contribution as a custome r or potential customer." 26 U.S.C. § 118(b). Th e 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 . . . th e provision of, services to or for the benefit of the person transferring th e 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 tha t McArthycontributed to the building of the sewer line was a contribution in aid of constructio n (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 th e very least was acting on behalf of potential customers of EPCO), and hi s contribution aided in the construction of a line

### Ibid. Neither party argues that we should disregard thi s 5 

### excep tion because it does not appear in the statute itself. W e would di sregard it anyway were it not for the history behind th e prov ision, which helps illuminate its meaning. The distinctio n between contributions to capital made by customers to procur e service and contributions to achieve indirect benefits to th e public at large was a familiar one in judicial decisions tha t preceded passage of 26 U.S.C. § 118 in 1954, and it is universally recognized that this statute was no more than a codification o f judicial decisions up to that point. The post-passage prese rvation of the distinction is evident from such cases as Teleservice Co. of Wyo ming 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 c ustomer cont ributions in aid of construction from the exclusion fo r contributions to capital.
EPCO does not argue in this Court that the contribution i n 6 

### question was not income within the meaning of the Sixteent h Amendment. Its argument is based solely on the statute.
-5- 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 normallybe assumed "to encourage the provision of services . . . unless it is clearly shown that the benefit of the public as a whole was th e primary motivating factor in the transfers." 5

The "public benefit" exception, as w ell as the general exclusion for contributions to capi tal, has its origin in a 1925 Supreme Court decision which held that cash subsidies as well as land and buildings provided by the gover nment of Cuba to a railroad company to construct a railroad i n 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 thi s conclusion because it found that the payments "were not made for services rendered or to be rendered" and were not "profit s or gains from the use or operation of the railroad." Id. at 633.
EPCO contends that McArthy's contributions to the sewer line

### -6-

were not made to encourage service to McArthy's property, but instead to benefit the public. McArthy would have gotten sewage treatment for hi s property regardless of the method chosen. He ch ose what was, both for him and EPCO, the far more expensive method of sewage treatment only because the alter native would have led to more water pollution. While EPC O obvious lycannot deny that the sewage line provides its customer wit h 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 motivati on for choosing one sewage treatment method over another. The record does no t convince us that McArthy's primary motivation was an altruistic concern fo r the environment beyon d his own development. The Tax Court found that the on-site treatment fac ility "would have been noisy and unsightly and would have emitted unpleasant odors, which would have detrimentally affecte d propertyvalues. . . . [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 wa s clearly erroneous. We hold that it is not unreasonable to think that a deve loper seeking sewage service for his property would pay an extr a $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 thi s was, in fact, Mr. McArthy's primary motivation. This conclusion i s reinforced by the pro vision in the contract that states that the $200,000 contribution was to be in lieu of fees that EPCO could have charged mobile hom e owners to connect their property to sewage service. Add to thi s evidence

### -7-

the natural assumption that a developer acts to maximize his profit and no t 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 th e
sewer line was a taxable contribution in aid of construction under 2 6 U.S.C. § 118.

III.

The que stion of how to value what EPCO got, and thus how much t o includ e in its income, remains. The Tax Court held that $35,625 wa s includible in income for the year 1989 - the full amount of money paid fro m the escrow account th at year to contractors and subcontractors working on the sew er line. These payments went to defray debts for which EPCO wa s 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 i s income to that person. E.g. , Old Colony Trust Co. v. Commissioner , 27 9 U.S. 716 (1929).

EPCO re plies that this general rule does not apply where, as here , the debt paid was itself created as part of the same transaction tha t included the payment. Imperial would not have built the sewer line, and thus would not have c ontracted the $200,000 in obligations that were paid out of the escrow account, if McArthy had not agreed to contribute th e $200,000 in the first place. EPCO says that wha t it actually received was not money or the liqu idation 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 ($340,0 00 from Imperial and $200,000 from McArthy), but the present value of the stream of future income expected to be realized from customer s tapping on to the sewer line - an amount EPCO fixes at abou t $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 $360,00 0 value of the line less the

### -8-

$340,000 paid by Imperial).

We agre e with EPCO that the debt payments themselves were not ips o fact o income to it. See Fox v. Harrison , 145 F.2d 521 (7th Cir. 1944 ) (payment of debt not income when debt incurred a s part of same transaction that envisioned the p ayment). We further agree that what EPCO got out of this transaction was the sewer line. But the qu estion of the value of the
sewer line is one of fact, and the Tax Court, the finder of fact, neve r reached that question, having stopped its analysis with the conclusion tha t what EPCO got was payment of its debts. The income expected to be produce d by the line from McArthy's mobile-home park is certainly one possibl e 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 hav e difficulty believing that businesspeople would pay $540,000 for an asset that, immediately upon purchase, became worth only $360,000. Th e difference may be due, at least in part, to the possibility that othe r
users might tap on to the line in the future - for example, users on the ad joining property, whose owners contributed half of the $200,000

. This issu e of fact needs to be explored further in the court of firs t 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 inconsisten t with this opinion. The Tax Court may in its dis cretion allow either party to introduce additional evidence.

It is so ordered.

### -9- A true copy.

Attest:

CLERK, U.S. COURT OF APPEALS, EIGHTH CIRCUIT.