Federal Tax Consequences of State Economic Development Incentives, 0317 SCBJ, SC Lawyer, March 2017, #37
| Author | Burnet R. Maybank III, Lindsay N. Richardson and Sam Johnson, J. |
Burnet R. Maybank III, Lindsay N. Richardson and Sam Johnson, J.
South Carolina, like many states, has a rich mix of economic development incentives. These include income tax credits, sales tax exemptions, property tax exemptions and credits as well as withholding tax credits. Incentives also include cash grants, e.g., Department of Commerce Set Aside Funds, and the occasional county grant. The state and county may also directly pay for public infrastructure to benefit an economic development project. South Carolina Tax Increment Financing (TIF) statutes may result in substantial funds benefiting private real estate developers.
Consider for example, a corporate manufacturer which locates in Berkeley County with a $40 million capital investment and 200 employees. The manufacturer will likely receive a fee-in-lieu property tax incentive together with a Special Source Credit, which will substantially reduce its property tax bill otherwise owing. The manufacturer will likely receive a withholding tax credit based upon its payroll under the Enterprise Zone program. The manufacturer will purchase its machinery and equipment sales tax free under a sales tax exemption, and will pay little in corporate income taxes as all of its customers are located in other states.
Will the receipt of these incentives trigger federal income tax liability to the fortunate recipient? What if the manufacturer is an LLC taxed as a partnership? The answer depends on the type of incentive and the type of entity to which the incentive is given.
On May 23, 2008, the Internal Revenue Service issued Coordinated Issue Paper LMSB-04-0404-023 (CIP) addressing its position as to the federal tax treatment of certain state and local tax incentives. The state and local tax incentives covered are referred to as "location incentives." These types of incentives include abatements, credits, tax rate reductions and exemptions which are used by state and local governments to induce companies to relocate, expand or maintain facilities in a particular area.
The IRS concluded in its CIP that such state and local tax incentives generally (1) do not result in federal gross income to the recipient corporate taxpayer; (2) are not a contribution to the taxpayer's capital; (3) do not reduce the taxpayer's basis in its property; and (4) are not allowed as a deduction for taxes that are paid or accrued. Alas, the IRS's interest in state tax incentives did not end there. The IRS does consider receipt of some incentives as subject to federal income taxes, most recently in Maims v. CIR. Maines v. CIR, 144 T.C. No. 8 (Tax Court 2015), and the IRS considers receipt of some incentives by non-corporate entities as taxable income.
As stated in IRS Tier I Issue: IRS Section 118 Abuse Directive #4, the IRS issued this CIP not to declare incentives as taxable income but rather to counteract a strategy used by some corporate taxpayers of claiming a current federal income tax deduction for the full state or local tax incentive amount as if that amount had actually been paid by the taxpayer as a state and local tax. Under this strategy, the corporate taxpayer would recognize the incentive amount as gross income for federal purposes, but not as taxable income because, as discussed below, such amount would be treated as a contribution to the taxpayer's capital. In essence, the corporate taxpayer would get the federal tax deduction without any corresponding taxable income.
This article summarizes the general principles of incentives as subject to federal income taxes and attempts to apply those principles to South Carolina's incentives.
Receipt of incentives by corporations
IRC Section 61(a) provides that, except as otherwise provided, gross income means all the income from whatever source derived. The U.S. Supreme Court has nevertheless held that governmental grants to corporations for economic development purposes were not income within the meaning of IRC §61 in Edwards v. Cuba Railroad Co.1 There were subsequently a number of Supreme Court and lower court cases on the related subject of whether government grants constituted a contribution of capital to the corporation. Congress finally stepped in and enacted IRC §118 in 1954. Pursuant to this statute, the IRS issued Regulation 1.118-1, which now provides:
Contributions to the capital of a corporation.
In the case of a corporation, section 118 provides an exclusion from gross income with respect to any contribution of money or property to the cap-ital of the taxpayer ... Section 118 also applies to contributions to capital made by persons other than shareholders. For example, the exclusion applies to the value of land or other property contributed to a corporation by a governmental unit or by a civic group for the purpose of inducing the corporation to locate its business in a particular community, or for the purpose of enabling the corporation to expand its operating facilities (emphasis added).
In summary, governmental grants given to corporations are generally not considered taxable income. Even if they were included in gross income, they are excluded from taxation under IRS section 118.
Congress enacted section 118 to codify judicial decisions dealing with income taxes and simultaneously enacted section 362(C), which assigns a zero basis to corporate property acquired through governmental grants. The net effect is to allow the exclusion of the grant from gross income, while prohibiting the taxpayers from adding the value of the grant to the basis of the asset. Congress did not likely consider the business entity issue when it enacted section 118 in 1954. Very few businesses of the type likely eligible for economic development incentives in 1954 were general or limited partnerships, and LLCs were not recognized by any state until Wyoming in 1977.
Receipt of incentives by partnerships and LLCs
No Section 118 exclusion
In a 1972 Revenue Ruling,2 the IRS held that consideration paid to a non-corporate entity for membership certificates was not includable in gross income and should be treated as contribution to capital under section 118. The 1972 Revenue Ruling provided no explanation why section 118 applied to a non-corporate entity. Similarly, in a 1979 Technical Advice Memorandum3 the IRS held that a governmental grant to a non-corporate taxpayer, a public utility partnership, qualified for section 118 exclusion. Lastly, in a 1980 PLR4 the IRS held that governmental grants given to a limited partnership for the construction of a hotel and residential units were excludable from gross income as they represented a contribution to the capital of the partnership.
Alas, the IRS subsequently reversed course in a 1982 General Counsel Memorandum5 which dealt...
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