IRS increases scrutiny of 'Section 118 Abuse'.

• Author: Atkinson, James L.

Regardless of audit experiences, any taxpayer that excludes a receipt from gross income as a non-shareholder contribution to capital should expect scrutiny by the Internal Revenue Service. The IRS has designated "Section 118 Abuse" a Tier I issue under its Industry Issue Focus program. Through this enforcement initiative, the IRS has substantially increased its scrutiny of return positions in which the taxpayer relies upon section 118(a) of the Internal Revenue Code to exclude the receipt of cash or other property as a non-shareholder contribution to capital. Although the IRS's concern is largely focused on three specific areas of perceived abuse, all taxpayers claiming the benefits of section 118(a) are likely to feel the effects of this enforcement initiative. This article is intended to assist taxpayers in understanding the basic tax principles applicable to non-shareholder contributions to capital, the IRS's principal concerns and the focus of the IRS examination activity, and practical suggestions in preparing for an IRS examination in this area.

Non-Shareholder Contributions to Capital: The Basics

Section 118(a) provides a very simple rule. In the case of a corporation, capital contributions are not includible in gross income. This exclusion applies equally to capital contributions made by nonshareholders. Treas. Reg. [section] 1.118-1. Amounts that constitute "contributions in aid of construction" or CIACs, however, are excluded from the definition of capital contributions and must be included in gross income. I.R.C. [section] 118(b). Thus, in determining whether a receipt is excludable from gross income as a non-shareholder contribution to capital, the recipient must show that (i) the payment is not a CIAC and (ii) the payment otherwise falls within the definition of "contribution to capital" for purposes of section 118(a). Courts and the IRS consistently adhere to this two-step analytical framework.

1. Step One: CIACs

   Under section 118(b), the term "contribution to the capital of the taxpayer" does not include any contribution in aid of construction. Prior to 1986, section 118(b) treated CIACs received by regulated utilities as capital contributions excluded from income under section 118(a). Congress reversed this rule in 1986, and all CIACs became taxable. (1) This blanket exclusion of CIACs from the scope of section 118(a) was loosened somewhat in 1996, when CIACs paid to certain water and sewer utilities became excludable from income in certain circumstances. (2)

   The 1986 legislative history of section 118(b) reveals that Congress subjected CIACs to current taxation because they were viewed as a form of prepayment for future services that the taxpayer would eventually provide to its customers. The legislative history underlying the 1954 enactment of section 118(a) similarly focuses on payments providing intangible benefits other than as a "payment for future services." (3) The 1986 legislative history notes that Congress believed "that all payments that are made to a utility either to encourage, or as a prerequisite for, the provision of services should be treated as income of the utility and not as a contribution to the capital of the utility." (4)

   Neither the Code nor the Treasury regulations define a CIAC. Instead, the 1986 legislative history again serves as the touchstone. It notes that a taxpayer is considered to have received property to encourage the provision of services for the payor's benefit if the transfer (i) is a prerequisite to the provision of services, (ii) results in the provision of services earlier than would be the case had the property not been received, or (iii) otherwise causes the transferor to be favored in any way. On the other hand, where it is clearly shown that the benefit of the public as a whole was the primary motivating factor in the transfer, the payment is not treated as a CIAC. (5)

   In interpreting section 118(b), the IRS consistently has relied upon these criteria and the distinction between payments for the public good and payments intended to provide a direct benefit to the payor. (6) In Notice 87-82, the IRS posited as an example of a CIAC a payment to a utility for the relocation of utility equipment (such as electric or gas transmission or distribution lines) related to the provision of electric service by a utility:

   For example, a customer of a utility moves its business office to another location and is required to pay the utility a fee to relocate the utility facilities to the new office site. The utility has received the fee as a prerequisite to the provision of services to the new location, and thus the fee is a CIAC under section 118(b) and is included currently in the utility's income. In addition, assume a real estate developer pays a fee to a utility in return for the utility extending new underground services to a particular tract being developed. Since the payment is being made to or for the benefit of the developer and since the fee is a prerequisite to the provision of underground services to the tract, the fee is a CIAC and currently included in the utility's gross income. In contrast, Notice 87-82 agreed that where the payment was made to provide a benefit to the public at large rather than a direct benefit to the payor, the payment is not a taxable CIAC. Thus, relocation payments received by a utility under a government program for placing utility lines underground are not treated as a CIAC where the relocation is undertaken for purposes of community aesthetics and public safety and not for the direct benefit of particular customers of the utility in their capacity as customers. (7)

   As is clear from the 1986 legislative history, the focus should be on whether the payment is being made by the payor in its capacity as a customer or potential customer of the recipient (even if that customer is a governmental entity). The 1985 House Report is explicit that in enacting section 118(b), Congress was concerned about pre-payments for future services, as the IRS itself acknowledged in Notice 87-82. Unfortunately, possibly in reaction to what it perceives to be abusive interpretations of section 118 generally, the IRS recently has departed from the original legislative intent and in recent private letter rulings has instead characterized as a CIAC a payment that provides any benefit to the payor, irrespective of an actual or potential customer relationship. Two sets of private letter rulings illustrate this recent trend.

   In PLR 200248014 (Aug. 22, 2002), a developer was required to pay a utility to bury power lines along the periphery of an intended building site. Although the lines were not necessary to provide electric service to the new building, the county required the developer to incur the costs of burying the lines as a precondition to obtaining the necessary building permits. Burying the lines was a component of an ongoing county beautification project. The National Office ruled that because the developer's payments were required by the county for purposes of community aesthetics and general public benefit, the utility was not required to include the payments in income as a CIAC.

   On essentially identical facts, however, the National Office ruled more recently that the utility is required to recognize the payment from the developer as gross income. This time, in PLR 200542001 (July 6, 2005), the National Office concluded that (i) the developer derived a benefit from the payment since the payment enabled it to obtain a building permit, and (ii) the utility provided a service in exchange for the payment, namely the physical burying of the existing lines.

   In PLR 200133036 (May 22, 2001), a developer again was required to pay for the burying of existing power lines in order to obtain a county building permit. Here, the developer was required to pay to widen the road adjacent to the construction site, and the existing power lines were located in the path of the widened road. Thus, to obtain the building permit, the developer had to pay the utility to relocate the lines so that the developer could arrange to have the adjacent road widened. The relocated lines had to be placed underground pursuant to a municipal ordinance. The National Office ruled that the utility did not receive a taxable CIAC, because the relocation of the lines to facilitate the widening of the road was undertaken to promote public safety.

   On essentially identical facts, however, the National Office ruled in PLR 200541036 (July 5, 2005) that the utility had received a taxable CIAC. As in PLR 200542001, the IRS concluded that the developer received a benefit in the form of the building permit, and that the payment to the utility was for a service (the burying of the lines) that made receipt of that benefit possible.

   Although private letter rulings are not precedential and taxpayers rely upon them at their peril, this shift in the National Office's ruling posture is nonetheless disturbing. The legislative history of section 118(b) and even the IRS's own published guidance defining a CIAC suggest a more direct linkage between the benefits received by the payor and the services provided by the payee, and that this linkage should relate to an actual or prospective customer relationship. As Notice 87-82 provides, a CIAC is a receipt in the nature of a prepayment for future services to be provided by the recipient to or for the benefit of the payor in its capacity as a customer. Unquestionably in the context of an electric or gas utility, this standard contemplates the future provision of electric or gas service, as opposed to the present service of burying or relocating existing power lines or pipelines.

   In its more recent rulings, the National Office separately analyzes whether the payor received any benefit by reason of the payment to the utility, and independently, whether the utility provided any service to the payor in exchange for the payment. The only linkage...