Refundable State and Local Tax Credits

By Danny R. Snow, CPA, Memphis, TN

Editor: John L. Miller, CPA

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 However, the Office of Chief Counsel, through a recent legal memorandum and other informal nonprecedential advisories, has provided insight as to the treatment of these credits.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 the IRS in this CIP, “Tax benefits are not ‘money or property contributed to a corporation.’”

The IRS, by concluding that these state and local tax incentives are not gross income and thus are not contributions to a corporation’s capital, also eliminated the basis reduction under Sec. 362(c). When corporations receive property other than money as a capital contribution from a nonshareholder, Sec. 362(c) requires the basis of the property to be reduced to zero. The IRS reasoned that tax incentives are used to reduce state and local tax liabilities and are not used to purchase property.

Bifurcated Approach

The Service took a bifurcated approach in addressing a refundable credit applied to a state franchise tax. In Chief Counsel Advice (CCA) 200842002, issued in October 2008, the IRS applied the “tax benefit rule” in determining the proper treatment of a credit applied under the state of New York’s Empire Zones Program to a corporation’s state franchise tax liability. The IRS concluded that a reduction of the state franchise tax attributable to a credit under this program was generally deductible under Sec. 164 by a cash-basis C corporation. However, according to the CCA, any portion of the credit that exceeds the taxpayer’s liability and results in the receipt of a cash payment attributable to refundable credits would be included in federal gross income under Sec. 111.

This bifurcated approach was also applied by the Office of Chief Counsel in determining the proper treatment of two tax credits of the Michigan Economic Growth Authority (MEGA): the business activity credit (BAC) and the employment credit (EC) (FAA 20085201F). The IRS concluded that because the BAC is nonrefundable, it is treated as a reduction in the taxpayer’s state tax expense. However, because the EC is refundable, it is gross income to the extent that a corporation receives a refund. Otherwise, it too is treated as a reduction of state tax expense. In this case, the taxpayer entered into an agreement with MEGA whereby the taxpayer was required to construct a new manufacturing facility and create a minimum number of “qualified new jobs.” If the taxpayer fulfilled the terms of the agreement, it would receive both BAC and EC credits.

The MEGA credits are available to offset the Michigan Single Business Tax (SBT). The agreement requires that the taxpayer annually demonstrate that it continues to meet the terms of the agreement. If successful, the taxpayer reports the credits on its annual SBT return. The EC is refundable to the extent it exceeds the taxpayer’s SBT liability in any given year.

The analysis and conclusions in FAA 20085201F closely follow those from CCA 200842002 and LMSB-04-0408- 023, discussed above. The Service applied the analysis in Snyder, T.C. Memo. 1988- 320 (also cited in LMSB-04-0408-023), which held that reductions in certain Ohio taxes did not involve any right on the part of the taxpayer to receive an amount of money from the state of Ohio, only a right to pay less state tax. Because the business activity credit was not refundable, the IRS reasoned that the findings in Snyder were applicable in this situation. The employment credit, unlike the BAC, was refundable and therefore required a different analysis.

The IRS took the bifurcated approach in addressing the treatment of the EC by stating that “refundability, by itself, does not cause the entire credit to be treated as a payment from the state.” Again, the Service determined that the portion of the credit applied to reduce taxes is treated as a reduction of tax. The amount of credit that exceeds the liability and is “made available” to the taxpayer as a cash payment is included in income unless an exclusion applies.

Although a portion or all of the EC may be gross income, the IRS once more concluded that the taxpayer could not exclude the amount reportable as gross income as a contribution to capital. Here, the Service applied factors from Chicago, Burlington & Quincy R.R. Co., 412 U.S. 401 (1973), for identifying a capital contribution. The refundable portion of the EC failed to meet the definition of capital contribution as established in this case. Following the reasoning in LMSB- 04-0408-023, the Service has again concluded that Sec. 118 does not apply; therefore, the refundable portion of the EC is not excludible from income.

While these three advisories may not be used or cited as precedent, they do indicate the direction that the IRS will likely follow when published guidance is issued.


John Miller is a faculty instructor at Metropolitan Community College in Omaha, NE. Danny Snow is a member in charge of tax with Thompson Dunavant PLC in Memphis, TN, and a member of the AICPA Tax Division’s IRS Practice and Procedures Committee. For further information about this column, contact Mr. Miller at

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