The Letter and the Law

ongratulations. Our EDC has decided to grant you $X million just to be sure you select our fine state for your new facility. Now sign the award contract right here ?

      Nice, huh? But not so nice if you have to pay taxes on the money to Uncle Sam, making the true value of the award worth perhaps only 65 cents on the dollar.

      The tax exposure is not readily apparent, and many people wrongly assume the awards are not taxable, since it seems odd that a government so willing to give would so quickly take away. However, transfers of cash or property, even when from a governmental or quasi-governmental entity such as an economic development corporation (EDC), are indeed taxable income ? unless made non-taxable by a specific exclusion.

      The importance of gaining non-taxable treatment cannot be overstated, as it will reduce not only the federal tax, but, to the extent state taxes are based upon the amount determined to be taxable at the federal level, may reduce state taxes as well. There are certain characteristics to look for before signing the award agreement that could help to support the non-taxable status of many grants.

      The little-known Internal Revenue Code Section 118 offers the best support for excluding the grant from taxable income. While contributions to capital by shareholders of a corporation have always been non-taxable, the treatment of contributions to capital by non-shareholders has not been as clear, resulting in a long history of disputes with the IRS about its applicability. Under Section 118,

contributions to capital of a corporation by non-shareholders

may be excluded as taxable income.

Worth the Trouble to Avoid Trouble?

      The IRS doesn’t like to be generous with exclusions from income, however, so it has interpreted this exclusion narrowly and litigated numerous cases on this issue. The IRS has even gone so far as to make this a

Tier One" audit issue, so that a return that claims the exclusion is likely to warrant close examination by the IRS. The application of this provision to EDC grants is a fairly new phenomenon, but as EDC cash awards have proliferated, the tax dollars at stake have increased as well, making the IRS very reluctant to offer any blanket refuge for recipients.

      A case in point: Last year, I was called by a client after it had received a Texas Enterprise Fund award and the award agreement had been signed. When the client perceived the tax issue, they called to discuss their tax liability. The TEF, at the time, was unaware of the issue and was unable to change the agreement in any manner.

      Although I believed the client had a right to the exclusion, given the likelihood of controversy upon audit of the client’s return, I recommended that the client try to obtain a private letter ruling (PLR) from the IRS that the grant was non-taxable.

      Preparation of a ruling request is tedious, expensive and time-consuming. In most cases, the requesting taxpayer will have to pay a user fee (now set at $11,500) up front simply for the privilege of having the IRS review the request, regardless of the outcome. The taxpayer also has to submit voluminous documentation and respond to factual questions from the IRS. The ruling process usually takes six to nine months and, of course, attorneys’ fees will be incurred as well.

      This client finally received a favorable PLR, the first of its type issued in many years. The PLR will provide the client (and its accountants) security against IRS attack. However, a PLR is issued solely to the taxpayer that receives it and may not be relied upon by other taxpayers. Each grantee needs to evaluate its own particular facts to determine if a PLR is advisable and potentially obtainable.

      There are three issues that are often among the most contentious for the IRS:

      Permanent Tax Reduction or Merely Deferral? Even when the exclusion is available, it may not be a permanent exclusion. The IRS exacts its pound of flesh for the exclusion by denying a cost basis for the capital assets purchased with the funds. This means that the taxpayer will have greater gain if and when there is a subsequent disposition of the assets, thereby converting the tax benefit into a long-term deferral of taxes rather than a permanent reduction. Of course, depending on how long the asset is kept, tax deferral could be as beneficial as an exclusion.

      The basis reduction also means that, if the grant is spent on assets that are depreciable, such as buildings or equipment, the deductions that may have been allowed will be lost. There would be no loss of depreciation deductions, however, if the grant is spent on land, since land is not a depreciable asset. Therefore, if the grantee is using the money for the acquisition of both land and buildings or equipment, it will be most beneficial to be able to trace the use of the funds to the acquisition of the land. The basis reduction and the allocation and timing of it will be of interest in any IRS audit.

      Partnership, LLCs Not Eligible. As enacted, Section 118 refers only to corporations, not partnerships or LLCs. The reference to corporations seems to have no policy reason behind it, however. More likely, the omission occurred because partnerships were not used by many businesses and LLCs didn’t even exist when the provision was enacted. Nevertheless, under the letter of the law, partnerships and LLCs are not eligible. Depending upon the amount at issue, partnership or LLC businesses may want to consider restructuring in advance of receiving the award. Otherwise, they will need to consider carefully their legal support for exclusion either under Section 118 or outside of Section 118.

      Intent to Contribute to Capital. The IRS wants to know that the grantor’s intent was to make funds available for investment in capital assets, such as land, buildings, or equipment. Therefore, if the purpose of the award is to cover the grantee’s operating expenses, to discount operating costs, or to pay for goods or services provided to the government by the grantee, non-taxable status may be questioned.

      EDCs can help out award recipients by considering award agreement terms with an eye to these issues. The EDCs may be able to offer the recipients a federal tax benefit at no cost to the EDC. Whether or not a particular grant qualifies for the exclusion is a facts-and-circumstances test with no clear-cut answers. However, the language used in the award will greatly influence the IRS’s view of the award.

      For example, the references to jobs in an award agreement can take all kinds of forms, but shading the terms can affect how the IRS views the grant. The most helpful agreement would note requirements for the grantee to spend money on capital assets, perhaps specifying a land parcel or facility and containing no reference to job creation.

      If the award is contingent on both capital investment and job creation, the more vague the reference to job creation, the better. If jobs are defined and a hiring schedule must be specified, the most helpful agreement would contain general references to economic development in a particular locale and state that the grant is awarded, but the schedule for payment of the grant turns on the timing of job creation. This helps support the grantee’s position that it received the grant for capital investment.

      If the grant is explicitly contingent on creating a specific number of jobs, defined by pay and with a required hiring schedule and a clawback provision, the IRS will likely question the position of non-taxability. In situations where the government funds are paid out in direct correlation to the recipient’s payroll, securing exclusion of the grant from income may be more difficult. Therefore, the more references in the agreement to the grantor’s intent to foster economic development through investment in the capital assets of the community, the better.

      Making the case for a Section 118 exemption is not simple, nor is it cheap. However, those who go into the process aware of the challenges and prepared for IRS scrutiny can reap a double reward: receipt of the grant and no tax on it.