Refundable state and local tax credits.

• Author: Snow, Danny R.

It is common for state and local governments to offer tax incentives as a way to encourage businesses to relocate to their region or expand existing local operations. These incentives can take the form of tax rate reductions, tax abatements, tax credits, property or income tax exemptions, and credits for the creation of additional jobs. The IRS has not issued published guidance on corporations' tax treatment of refundable state and local tax credits. However, the Office of Chief Counsel, through a recent legal memorandum and other informal nonprecedential advisories, has provided insight as to the treatment of these credits.

Income Treatment

Taxpayers have traditionally treated such credits and incentives as reductions of state and local tax expense for federal income tax purposes. However, according to the Service in a coordinated issue paper (CIP) released in May 2008, some corporate taxpayers are beginning to report these credits "as an incentive payment to the taxpayer, coupled with a payment of the tax by the taxpayer" ("State and Local Tax Incentives," LMSB-04-0408-023). The corporation claims a tax deduction for the full local tax liability under Sec. 164. It then reports an item of gross income under Sec. 61, which, however, it excludes from income as a contribution to capital under Sec. 118. Finally, the corporation reduces the basis of property in an amount equal to this excluded amount under Sec. 362(c). In the May 2008 CIP, the IRS discussed each component of this treatment separately.

The CIP addresses the reporting of the tax incentive as an item of gross income. Sec. 61(a) states that unless otherwise provided, gross income means all income from whatever source derived. Citing Glenshaw Glass, 348 U.S. 426 (1955), the Service concluded that when a taxpayer is entitled to a local tax incentive such as a tax abatement, credit, deduction, or rate reduction, "the taxpayer generally is not regarded as realizing an accession to wealth that results in gross income." Instead, the IRS stated that these state and local tax benefits are treated for federal income tax purposes as a reduction in the taxpayer's state or local tax liability.

By concluding that these state and local tax incentives are not gross income, the Service effectively eliminated the amount's exclusion as a contribution of capital. The regulations under Sec. 118 provide for an exclusion from income of contributions of money or property to a corporation. According to...