PRIVATE RULING 9131023 "This document may not be used or cited as precedent. Section 6110(j)(3) of the Internal Revenue Code." Dear * * * This is in reply to a letter dated October 30, 1990, and subsequent correspondence, in which a ruling is requested on behalf of Association that the money it receives under a settlement agreement, and interest earned on accounts funded with the settlement payments, be considered excludible from the gross income of the Association. FACTS You have represented that Association qualifies as a homeowners association under section 528 of the Internal Revenue Code. Association was incorporated under the laws of state P for the purpose of preserving and maintaining the common areas of the property owned by the unit owners, who also own and control Association. On a, Association filed suit on behalf of the unit owners against M, the developer of the property that Association was formed to maintain. The suit alleged various construction defects to common areas of the property as well as M's failure to establish adequate cash reserves to repair and/or replace the defective property. Association sought to recover an amount sufficient to repair or replace the defective common area property. In b, Association reached a settlement with M on behalf of the unit owners. The settlement agreement provides for the following payments: "1) an initial lump sum payment of x dollars from M to Association; 2) a payment of approximately y dollars from M to N, an insurance company, to establish an annuity (discussed below); and 3) annual and periodic annuity payments from N to Association." Association intends to place the lump sum payment of x dollars in a physically segregated, interest bearing account. The payment, together with the interest earned thereon, will be used to repair and replace the defective property over time as such repairs and replacements become necessary. The annuity will be owned exclusively by N. On and after the annuity commencement date, O, a second insurance company, will pay annual annuity payments to Association at an annual annuity rate of z dollars. The annuity
contract also provides that O will make three additional payments to Association on dates specified in the contract. As with the lump sum payment, Association will place amounts received under the annuity contract in physically segregated, interest bearing accounts. The payments, and interest earned thereon, will be used to repair and replace defective property over time. The total amount Association is to receive in initial lump sum and annuity payments is the settlement parties' estimation of the present value of the damages Association is likely to incur over time from the construction defects. The parties arrived at this figure after consulting with several engineering firms to evaluate the defects. You have represented that Association has acted at all times for and on behalf of the unit owners, and that all funds are to be held for their benefit. The unit owners, however, will not have the right to receive or withdraw any payments received, any amounts deposited, or any interest earned. All funds will remain the property of Association until expended for the repair or replacement of the common areas. LAW AND ANALYSIS Section 61(a) of the Code provides that, except as otherwise provided, gross income means all income from whatever source derived. Under section 61(a)(4), interest is an item includible in gross income. Similarly, under section 61(a)(9), amounts received under an annuity are includible in gross income. Section 528(b) of the Code imposes a tax for each taxable year on the homeowners association taxable income of every homeowners association. Section 528(d)(1) defines "homeowners association taxable income" to be the excess of an association's gross income for the taxable year (excluding exempt function income) over the deductions allowed under section 528(d)(1)(B). Section 528(d)(3) of the Code provides that the term "exempt function income" means any amount received as membership dues, fees, or assessments from owners of condominium housing units in the case of a condominium management association, or owners of real property in the case of a residential real estate management association. Section 1.528-9(c)(4) of the Income Tax Regulations provides as an example of a receipt that is not exempt function income, interest earned on amounts set aside in a sinking fund. The treatment of amounts received as proceeds of a lawsuit or settlement depends upon the nature of the claim and the actual basis for recovery. If the recovery represents damages for lost profits, it is taxable to the recipient as ordinary income. If, however, the recovery is received as replacement of lost capital, it is not taxable. Raytheon Production Corp. v. Commissioner, 144 F.2d
110, 113 (1st Cir.), cert. denied, 323 U.S. 779 (1944); Freeman v. Commissioner, 33 T.C. 323, 327 (1959); Rev. Rul. 81-277, 1981-2 C.B. 14. In Rev. Rul. 81-152, 1981-1 C.B. 433, the Service considered a case where a homeowner's association instituted an action against the builder of a condominium development on behalf of the unit owners for damages arising from defects in the construction of the condominium development. The revenue ruling holds that the money received from the builder was not income to the association. In Rev. Rul. 79-220, 1979-2 C.B. 74, the taxpayer sued to recover damages for personal injuries sustained from the conduct of the defendant. Before trial, the parties reached a settlement that obligated the defendant to make a lump sum payment to an insurance company to purchase an annuity that would fund monthly payments to the taxpayer. The insurance company was the owner of the annuity contract and possessed all rights of ownership. The revenue ruling holds that the insurance company's purchase of the annuity contract was merely an investment by the company to provide a source of funds to satisfy the settlement obligation to the taxpayer. Accordingly, both the amount paid for the annuity contract, and the monthly payments to the taxpayer, were excludible from the taxpayer's gross income under section 104(a)(2) of the Code as damages received on account of personal injury or sickness. See also Rev. Rul. 79-313, 1979-2 C.B. 75. In the instant case, Association negotiated the settlement with M to compensate Association for the cost of correcting construction defects to common areas that Association is obligated to preserve and maintain. The money received by Association, in the form of both a lump sum payment and annual and periodic annuity payments, is intended to compensate Association for capital it will have to use in order to make the necessary repairs and replacements. Association intends to place the lump sum payments and the annual annuity payments in separate interest bearing accounts. The interest earned on the accounts also is to be used to make necessary repairs and replacements. In Rev. Rul. 65-29, 1965-1 C.B. 59, the Service addressed the question of whether interest realized from the investment of a damage award was excludible from the taxpayer's gross income under section 104(a) of the Code. On the taxpayer's suit for tortious injury to his wife, the Court awarded 416x dollars, which represented the present value of 520x dollars payable over the wife's estimated remaining life expectancy. The latter amount was the taxpayer's estimated reasonable cost of care, medicine, and medical attention for his wife over the same period. The taxpayer had unfettered control of the lump sum payment and the interest earned from investing it. Thus, the revenue ruling holds
that the lump sum payment was excludible from income under section 104, but the interest was taxable. See also Rev. Rul. 79-220, 1979-2 C.B. 74. In the instant case, Association maintains unfettered use of the invested funds and interest. These amounts will be set aside for the Association to draw upon to repair or replace common property. The unit owners have no right to draw on the funds or to receive a credit of any of the interest upon disposition of their units. Thus, the interest earned on the accounts is similar to interest earned on a sinking fund established by an association from an assessment on its unit owners. Accordingly, based on the facts submitted, and on the above law and rationale, we conclude the following: 1) the initial lump sum payment represents damages for lost capital and is not includible in Association's gross income; 2) the payment by M to N to purchase an annuity contract to fund payments to Association is not includible in Association's gross income; 3) the annual and periodic annuity payments represent damages for lost capital and are not includible in Association's gross income; 4) interest earned on investment of the lump sum payment Association receives under the settlement agreement is includible in its gross income. The interest will not be exempt function income for purposes of section 528 of the Code; and 5) interest earned on investment of the annuity payments Association receives under the settlement agreement is includible in its gross income. The interest will not be exempt function income for purposes of section 528 of the Code. We express no opinion as to the federal tax consequences of the transaction described above under any other provision of the Code. We express no opinion on the consequences to the unit owners of amounts received under the settlement agreement, or on whether Association qualifies as a homeowners association under section 528(c) of the Code. In accordance with the power of attorney submitted, we are sending a copy of this ruling to Association. Association should attach a copy of this ruling to its tax return for the taxable year in which the transaction covered by this ruling is consummated. This ruling is directed only to the taxpayer who requested it. Section 6110(j)(3) of the Code provides that it may not be used or cited as precedent.
Sincerely yours, Assistant Chief Counsel (Income Tax & Accounting) Peter J. Frederick Assistant to the Chief, Branch 2 Enclosure: Copy for section 6110 purposes TSLG SYNOPSIS: Private Ruling 9042036, below, taxes interest earned by an Association on settlement proceeds received as a lump-sum for repairs of construction defects by a developer. PRIVATE RULING 9042036 "This document may not be used or cited as precedent. Section 6110(j)(3) of the Internal Revenue Code." DATE: July 23, 1990 Dear * * * This is in reply to a letter dated January 30, 1990, in which a ruling is requested that with respect to the Association the interest earned on amounts received in settlement of a pending lawsuit constitutes exempt function income, as defined in section 528(d)(3) of the Internal Revenue Code. The facts and representations are as follows. In a, the Association received a settlement of a pending lawsuit for defective construction. In a, the Association received funds in the amount of c pursuant to the settlement. In b, the Association received funds in the amount of d also pursuant to the settlement. The funds received are earmarked for specific repair items. The funds are held in interest bearing accounts until they are used.
The Association has requested a ruling that the interest earned on the funds received in the lawsuit settlement be considered exempt function income, as defined in section 528(d)(3) of the Code. Section 528(a) of the Code generally provides that certain condominium management associations and residential real estate management associations are subject to federal income tax only to the extent provided in section 528(b). Section 528(b) imposes a 30 percent tax on the homeowners association taxable income received in a taxable year by a homeowners association, as defined in section 528()(1). Section 528(d)(1) of the Code defines the term "homeowners association taxable income." Generally, homeowners association taxable income is equal to the excess of the gross income (excluding exempt function income) of the homeowners association over the deducitons directly connected with that gross income (excluding exempt function income). The deductions allowed for purposes of computing homeowners association taxable income are the deductions generally allowed for computing taxable income, as modified by section 528(d)(2). See section 1.528-10 of the Income Tax Regulations. The term "exempt function income" is defined by section 528(d)(3) of the Code as any amount received as membership dues, fees, or assessments from (A) owners of condominium housing units in the case of a condominium management association, or (B) owners of real property in the case of a residential real estate management association. Section 1.528-(9)(a) of the regulations provides, in part, that exempt function income consists solely of income which is attributable to membership dues, fees, or assessments of owners of residential units or residential lots. It is not necessary that the source of income be labeled as membership dues, fees, or assessments. What is important is that such income be derived from owners of residential units or residential lots in their capacity as owner-members rather than in some other capacity such as customers for services. Generally, for the membership dues, fees, or assessments with respect to a residential unit or lot to be exempt function income, the unit must be used for (or the unit or lot must be expected to be used for) residential purposes.... Furthermore, income attributable to dues, fees, or assessments will not be considered exempt function income unless each member's liability for payment arises solely from membership in the association.
Section 1.528-9(c) of the regulations provides examples of receipts by homeowners associations that do not constitute exempt function income. These examples include amounts received from persons who are not members of the association and interest earned on amounts set aside in a sinking fund. In this instance, the income in question was interest income received from parties who were not members of Association. Since the income was not attributable to membership dues, fees, or assessments of owners of residential units or residential lots, the income is not exempt function income within the meaning of section 528(d)(3) of the Code. We express no opinion as to whether Association qualified as a homeowners association under section 528(c) of the Code. No opinion is expressed or implied regarding the application of any other provision of the Code or regulations. A copy of this letter should be attached to the income tax return filed by Association for the tax year affected by this ruling. A copy is provided for this purpose. This ruling is directed only to the taxpayer who requested it. Section 6110(j)(3) of the Code provides that it may not be used or cited as precedent. Sincerely yours, Assistant Chief Counsel (Passthroughs and Special Industries) Emil O. Muhs, Jr. Chief, Branch 7