Tax Treatment of Government Grants to Partnerships Becomes Less Clear

By Mark S. Heroux, CPA, Virchow, Krause & Company, LLP, Chicago, IL

Editor: Anthony S. Bakale, CPA, MT

Federal, state, and local governments have been providing tax incentives to businesses for many years. Along with the long history of government incentives to taxpayers, there is a long history of controversy over the tax treatment of these incentives. The question often is whether the tax incentive constitutes a nontaxable contribution to capital or whether it warrants treatment as gross income under Sec. 61.

Definition of Gross Income and Judicial Developments

Any discussion of the tax treatment of government incentives provided to taxpayers begins with Sec. 61, which states the general rule that “gross income means all income from whatever source derived.” Generally, all income is subject to taxation unless excluded by law (Glenshaw Glass Co., 348 US 426 (1955)). The concept of gross income developed by the courts and articulated in Glenshaw Glass treats as income all items that are clearly realized accessions to wealth. The Supreme Court stated:

Here we have instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion. [The circumstances of their acquisition] cannot detract from their character as taxable income to the recipients. (Id. at 431.)

The judicially developed concept of gross income does not, however, provide a bright-line test for the treatment of government payments.

Numerous cases involve this issue. In Edwards v. Cuba R.R. Co., 268 US 628 (1925), the government of Cuba made subsidy payments to a railroad corporation under a Cuban statute authorizing the payment of subsidies to railroad companies for railroad construction. The railroad company used the subsidies as capital expenditures to build the railroad. The Supreme Court held that the subsidies did not constitute taxable income but were a capital contribution to the recipient. In Helvering v. Claiborne-Annapolis Ferry Co., 93 F2d 875 (4th Cir. 1938), the court held that a subsidy from the state of Maryland to the defendant corporation for the maintenance of a public ferry was additional income and not a contribution to capital. Because the corporation used the subsidy for operating expenses and not capital expenditures, the court determined that the subsidy was income to the recipient.

In Detroit Edison Co., 319 US 98 (1943), the Supreme Court held that payments by prospective customers to an electric utility company to cover the cost of extending the utility’s facilities to their homes were part of the price of service rather than contributions to capital. In Brown Shoe Co., 339 US 583 (1950), the Supreme Court held that payments to a corporation by community groups to induce the location of a factory in their community represented a contribution to capital. The Court concluded that the contributions made by the citizens were made without anticipation of any direct service or recompense, but rather with the expectation that the contribution would prove advantageous to the community at large.

Case law on this issue concluded with the Supreme Court’s decision in Chicago, Burlington & Quincy R.R. Co., 412 US 401 (1973), which provides a five-factor test to determine whether a contribution to a taxpayer is excludible from income. In order to exclude the contribution from income a taxpayer must show that the contribution:

  1. Must become a permanent part of the transferee’s working capital structure;
  2. May not be compensation, such as direct payment for a specific, quantifiable service provided for the transferor by the transferee; and
  3. Must be bargained for.  


  1. The asset transferred must foreseeably result in benefit to the transferee in an amount commensurate with its value; and
  2. The assets ordinarily, if not always, will be employed in or contribute to the production of additional income.  

Sec. 118

Secs. 118 and 362(c) were enacted in 1954 as a direct result of the Brown Shoe case (August 16, 1954, ch. 736, 68A Stat. 39 and 118). Prior to the enactment of these sections, corporate taxpayers could not only exclude capital contributions from income, but they could also depreciate the increase in basis under Sec. 113(a)(8) of the 1939 Code. According to the legislative history of Sec. 118:

This [section] in effect places in the Code the Court decisions on the subject. It deals with cases where a contribution is made to a corporation by a governmental unit, chamber of commerce, or other association of individuals having no proprietary interest in the corporation. (S. Rep. No. 1622, 83d Cong., 2d Sess. 18 (1954))

Sec. 362(c) provides that a corporation would take a zero basis in any property received or acquired by a contribution to capital treated as nontaxable under Sec. 118.

Capital Contributions to Partnerships

The IRS’s position on nonpartner contributions to the capital of a partnership has changed over time. In Technical Advice Memorandum (TAM) 7950002, the Service ruled that nonpartner contributions to the capital of a partnership qualified for exclusion under Sec. 118. In Letter Ruling 8038037, the IRS ruled that grants made by a city to a partnership to develop a downtown area were excludible under Sec. 118.

The Service reversed its TAM 7950002 position and ruled in TAM 9032001 that Sec. 118 was inapplicable to partnerships. General Counsel Memorandum 38944, issued in 1982, more fully sets forth the IRS’s position that Sec. 118 applies only to corporations, although the IRS stated that whether the restriction of Sec. 118 to corporations “was intentional or merely an oversight is not known.”

Taxpayers contend that nonpartner contributions to the capital of a partnership are eligible for exclusion from income under the common law contribution to capital doctrine established by the line of cases beginning with Cuba R.R. and ending with Chicago, Burlington & Quincy R.R. However, in an Industry Director’s Directive issued on October 5, 2007, the IRS stated that the Large and Mid-Size Business Division’s position is that:

Neither Code Section 118 nor any alleged common law “contribution to capital” doctrine permits the exclusion from income of amounts transferred to a non-corporate entity by a non-owner. The legislative history to Code Section 118 is clear that the provision codified the preexisting case law, all of which case law addressed the issue of whether amounts transferred to a corporation by a non-shareholder were excludable from income. Thus, neither the preexisting case law nor the Code supports the argument that amounts transferred to a non-corporate entity by a non-owner are excludable from income. (Industry Directive #3 on Section 118 Abuse, LMSB 04-1007-069 (10/5/07))

Did Sec. 118 Repeal the Common Law?

There is no evidence in the legislative history that Congress intended to repeal the common law applicable to all taxpayers prior to the passage of Sec. 118. Congress’s intent was to eliminate the double dip provided to corporations under Secs. 118 and 113(a)(8) of the 1939 Code. A review of the common law before Sec. 118 shows that the entity status of the litigants was never at issue, which supports the conclusion that Congress did not intend to repeal the common law as it applied to noncorporate entities. “The common law . . . ought not to be deemed to be repealed, unless the language of a statute be clear and explicit for this purpose” (Fairfax’s Devisee v. Hunter’s Lessee, 11 US (7 Cranch) 603, 623 (1812)).

Coordinated Issue Paper on the Effect of Governmental Tax Incentives

On May 23, 2008, the IRS issued a coordinated issue paper for all industries that provides guidance on the treatment of a state or local location (or similar) tax incentive (Coordinated Issue Paper, State and Local Location Tax Incentives, LMSB-04-0408-023). In this paper, the IRS held that a state or local location tax incentive, regardless of form, does not give rise to gross income under Sec. 61 and therefore does not qualify for exclusion as a capital contribution by a nonshareholder under Sec. 118. “Location tax incentives” include “tax rate reductions, tax abatements, tax credits, exemptions from income or property tax, and tax credits for the creation of additional local jobs” offered by state or local governments to induce companies to relocate or expand existing operations.

General Welfare Doctrine

The IRS has long held that payments made under legislatively provided social benefit programs for the promotion of the general welfare are excludible from gross income. This general welfare doctrine applies only to government payments out of a welfare fund based on the recipients’ need and not as compensation for services. In Bailey, 88 TC 1293 (1987), acq. 1989-2 CB 1, payments made for the rehabilitation of the facade of property purchased from the Urban Redevelopment Authority of Pittsburgh under its facade grant program were excludible from gross income because the purchaser had no dominion over the facade and no control over the work performed, nor were any payments made to him.

Recent Government Grant Programs

One of the more typical recent government grant programs involves a state awarding matching grants to partnerships to provide funding to approved targeted industry-based businesses. The partnership will invest in a targeted start-up business, and the state will provide matching funds to increase the investment. The state’s matching funds are held in escrow until the state approves a targeted investment. Income earned on the escrowed funds is paid to a state-designated nonprofit entity. The partnership fully owns the invested funds only once the funds are invested in a targeted business. Returns on the investment from the matching funds are paid to the state-designated nonprofit entity.

Are State Funds Taxable to the Partnership?

It would appear that the escrowed funds are not taxable to the partnership. Under Glenshaw Glass, the partnership arguably does not have an undeniable accession to wealth, clearly realized, and over which the partnership has complete dominion. The partnership never had complete dominion of the escrowed funds. The state has to approve the investment of the escrowed funds. Once the investment is approved, the escrowed funds are turned over to the targeted business, which now has dominion over the funds. Any return on the investment does not inure to the partnership; rather, the return is paid to the state-designated nonprofit entity.

Under the common law contribution to capital doctrine it would appear that the funds, if identified as gross income to the partnership, would be excludible from income as contributions to the capital of the partnership. In this scenario, the grant funds would be a permanent part of the partnership’s working capital; the funds would not be direct payments for services; the partnership bargains for participation in the grant program; the grant funds would provide benefit to the partnership in an amount commensurate with the value of the funds; and the grant funds would contribute to the production of additional income to the partnership.

Under the recently issued coordinated issue paper, it would appear that the partnership could argue that the grant funds are similar tax incentives provided by the state to the partnership to induce the partnership to invest in state-targeted businesses to aid state economic development. Under the coordinated issue paper, as under the Glenshaw Glass analysis, the grant funds are not income under Sec. 61.

Finally, since the partnership has no dominion or control over the matching funds and any income generated by the matching funds is not paid to the partnership, it would appear that the funds are not taxable income to the partnership under the general welfare doctrine.


State grant programs in which a nongovernmental entity directly partners with the state to spur economic development are generally not designed to enrich the nongovernmental entity. The form of entity and terms of the grant programs must be scrutinized to avoid the many tax potholes that can upset a smooth government economic development program.


Anthony S. Bakale is with Cohen & Company, Ltd. Baker Tilly International in Cleveland, OH

Unless otherwise noted, contributors are members of or associated with Baker Tilly International.

If you would like additional information about these items, contact Mr. Bakale at (216) 579-1040 or


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