Treatment of Grants as Nonshareholder Contributions to Capital

By David J. Holets, CPA, Indianapolis, IN, and David L. Strong, CPA, Grand Rapids, MI

Editor: Frank J. O’Connell Jr., CPA, Esq.

Corporations are generally exempt from tax on contributions made to corporate capital. The general rule regarding contributions to capital is stated in Sec. 118(a): “In the case of a corporation, gross income does not include any contribution to the capital of the taxpayer.”

Application of this rule is generally clear in transactions with shareholders: A corporation recognizes no gain or loss on a shareholder’s contribution to the corporation’s capital. The corporation receives basis for the contribution equivalent to the basis of the transferor at the time of the transaction under Sec. 362. This allows shareholders to make tax-free investments in corporations without the threat of double taxation.

However, Sec. 118 does not limit the exclusion to shareholders. If a nonshareholder makes a contribution to the corporation’s capital, Sec. 118 may apply. In a series of court decisions and IRS rulings, this treatment has been upheld. However, the IRS and the courts have taken a strict interpretation of when this exclusion applies. The strict interpretation of the rules under Sec. 118 has resulted in significant controversy in this area. The IRS has made nonshareholder contributions to capital a Tier 1 examination issue, releasing several directives and rulings in the last several years. This item identifies some of the key legislation and judicial decisions establishing the law in this area and analyzes several of the most recent rulings and guidance.

Pre–Sec. 118 Case Law

Sec. 118 was enacted following the issuance of two Supreme Court opinions: Detroit Edison Co., 319 U.S. 98 (1943), and Brown Shoe Co., 339 U.S. 583 (1950). In Detroit Edison, the taxpayer was an electric utility that provided electrical service to commercial and residential customers. Because some of these customers were located outside the taxpayer’s existing range of service, they were required to make a one-time payment for connection to the utility. The taxpayer used these payments to supplement the construction of fixed assets used in energy transmission.

The taxpayer argued that these funds were gifts or nontaxable contributions to capital, not payment for services. The taxpayer claimed a carryover basis in any property received and/or constructed using the payments. The IRS argued that the payments were not gifts or nontaxable contributions to capital, but payments for services rendered by the taxpayer. The Court did not specifically address the issue of whether the payments qualified as nonshareholder contributions to capital in this case. It agreed with the IRS that the fees paid by the customers did not in form or substance equate to contributions but were payments for services. Therefore, assets acquired using the customer payments received a basis of zero for purposes of depreciation. The Court was not asked to rule on the issue of whether the payments were excludible as contributions to capital.

The decision in Brown Shoe reached a different result from Detroit Edison. In Brown Shoe, the taxpayer received funds and property from several different community groups to provide incentives for the construction and/or expansion of its manufacturing facilities. Generally, the taxpayer would receive property and/or funding if it constructed and operated a factory in a specific location for a minimum period of time. The taxpayer argued that the funds and property received from these community groups were nonshareholder contributions to capital excludible from taxable income. The taxpayer further argued that any structures constructed using funding received from these community groups should be subject to depreciation expense. The Court agreed with the taxpayer.

The key factor differentiating Detroit Edison from Brown Shoe is the nature of the contribution. In Detroit Edison, the fees paid by the customers were paid for a specific service—connection to the utility. In Brown Shoe, there was no specific service paid for by the community groups. The end result of the contributions was to increase the general welfare of the community. Therefore, the contributions were more akin to an investment in the company than a payment for services.

Enactment of Sec. 118

With the enactment of Sec. 118 in 1954, Congress acknowledged that contributions to the capital of a corporation should not be included in gross taxable income. However, it did not specifically address the question of nonshareholder contributions to capital. Instead, Treasury confirmed the results of Brown Shoe and Detroit Edison in Regs. Sec. 1.118-1. This regulation states that “the exclusion applies to the value of land or other property contributed to a corporation by a governmental unit or by a civic group for the purpose of inducing the corporation to locate its business in a particular community, or for the purpose of enabling the corporation to expand its operating facilities.” The regulation also prevents a taxpayer from claiming payments for goods, services, or subsidies to limit production as nontaxable contributions to capital.

Although Congress did not address nonshareholder contributions to capital in Sec. 118, it did resolve the issue of basis brought forward in Brown Shoe and Detroit Edison. Under Sec. 362(c), which was enacted at the same time as Sec. 118, any property that is considered a nonshareholder contribution to capital under Sec. 118 will have a basis of zero. If the taxpayer receives money instead of property, it must reduce the basis of either property acquired using that money or other property held by the taxpayer if no property is acquired within a period of 12 months after the date of receipt. In this way, taxpayers are allowed to exclude the payment received from income but are not allowed a deduction for expenses relating to that income, similar to the taxation regime employed for other taxexempt income.

Five-Part Qualification Test

Although the enactment of Secs. 118 and 362(c) added some clarity to the treatment of nonshareholder contributions to a corporation, there were still many unanswered questions. It was not until 1973 that many of these questions would be answered with the Supreme Court’s ruling in Chicago, Burlington, & Quincy R.R. Co., 412 U.S. 401 (1973) (CB&Q). In that case, the taxpayer operated a railroad. Several governmental organizations wanted the taxpayer to make safety improvements to some of its facilities and structures. The taxpayer agreed to maintain these improvements if the governmental organizations would pay for their installation. The taxpayer received reimbursement for the improvements, excluded the reimbursements from taxable income as a nonshareholder contribution to capital, and claimed depreciation deductions on the full basis in the improvements.

The original facts of the case date to activities before the enactment of Sec. 118 in 1954, but the Court established a five-part test to determine whether a nonshareholder payment to a corporation can be considered a contribution to capital that is still in use today. The test requires that any payment received must:

  • Become a permanent part of the corporation’s working capital;
  • Not be compensation for specific goods or services;
  • Be bargained for;
  • Result in a benefit to the taxpayer commensurate with its value; and
  • Be employed in or contribute to the production of income.

Current Developments

Although CB&Q established what has become the definitive test for whether a payment is treated as a nonshareholder contribution to capital, it also left a number of questions unanswered. The lack of certainty in this area has led to a number of conflicts between taxpayers and the IRS. The government has been particularly active in this area over the past three years with the issuance of a series of eight industry director directives (IDDs), two cross-industry coordinated issue papers (CIPs), two industry-specific CIPs, several other private letter rulings, and the litigation of several court cases.

In one IDD, LMSB-04-0307-026, the IRS directed its agents to review any claims that payments received by telecommunication companies under the Universal Service Fund program qualified as nonshareholder contributions to capital under Sec. 118. The IRS has recently litigated and won cases confirming this position. In Coastal Utilities, Inc., No. CV404-90 (S.D. Ga. 3/28/07), aff’d, 514 F.3d 1834 (5th Cir. 2008), the district court issued a lengthy opinion analyzing the proper treatment of these payments made under a federal communications program that was established to provide the public with telephone service at reasonable prices. The payments were made to a company based on one of several formulas that considered the company’s investment, operation, maintenance, and other expenditures. The court found that the Universal Service Fund payments were not nonshareholder contributions to capital primarily because the formulas used to determine the payments were based on the corporation’s actual investment, not anticipated investment. Therefore, the payments failed the first CB&Q test because they were intended to support operational expenses. The ruling in Coastal Utilities was followed in a 2009 district court decision, AT&T Inc., SA-07-CV-0197 OG (W.D. Tex. 5/4/09).

Although the court’s findings in Coastal Utilities were not surprising given prior case law, the opinion indicates a potential change in the established review process for nonshareholder contributions to capital. Although the court used the five-factor CB&Q test in its analysis, it did not rely on that test in making its decision. For example, in applying the third test, the court questioned whether an agreement with the government such as this would ever be truly “bargained for” in the same sense as with a private community group or other entity making a contribution to the capital of a corporation. The court also questioned the value of the fourth test requiring that the taxpayer receive a benefit commensurate with the value of the contribution. The court stated, “As Coastal notes in its brief, a ‘cash’ payment always provides a benefit commensurate with its value. But this truism sheds no guiding light on the issue at hand, because a ‘cash’ payment can either be income or a contribution to capital.”

The results in Coastal Utilities indicate that courts are becoming willing to consider other facts than those referred to by CB&Q’s five-factor test. In Coastal Utilities, although the five-factor test was considered, the final decision rested more on the perceived transferor’s intent as established by the formulas used to determine the amount of payment made under the Universal Service Fund program. It is not yet clear whether the results of this trend to focus on transferor intent will be favorable or unfavorable to taxpayers. In addition to the Universal Service Fund, the IRS has issued guidance on four other significant issues under Sec. 118.

Bioenergy payments: In April 2008, the IRS issued a coordinated issue paper (LMSB-04-0308-019) finding that payments made by the USDA’s Commodity Credit Corporation under its bioenergy program are income under Sec. 61. The IRS focused its analysis on the intent of the bioenergy program and highlighted three factors indicating that these payments are not made for a capital investment:

  • The program does not require the payment to be used to acquire any specific capital asset;
  • A bioenergy producer is not required to own the energy production facility to qualify for the payments; and
  • A drop in production may result in a requirement to repay the funds received to the government.
On June 4, 2009, the IRS issued LMSB 4-0808-041, indicating that any identified taxpayer claim that bioenergy payments should be excluded from income under Sec. 118 should be challenged on examination, but the issue is sufficiently well defined to be moved from Tier 1 status to monitoring status.

Underground storage tank remediation: In February 2009, the IRS issued a CIP (LMSB 4-1108-054) regarding payments received from state funds as subsidies to support the cleanup of contaminated underground storage tanks. The IRS has indicated that it is pursuing reasoning similar to that followed under the bioenergy program described above to treat such payments as income under Sec. 61. On June 3, 2009, the IRS issued LMSB-PQ-0509-130, indicating that this is a Tier 1 examination issue.

Nonrefundable state and local tax incentives: The IRS has issued several documents regarding a perceived abuse of Sec. 118 by treating nonrefundable state and local tax incentives as contributions to capital. Under a typical scenario, a taxpayer receives an incentive to locate or expand a business in a specific location. This incentive may come in the form of a credit against taxable income or as a direct reduction or abatement of tax due. The taxpayer increases tax expense by the amount of the credit or abatement received, excludes that amount from income, and then reduces any related asset basis as required by Sec. 362(c).

The IRS has used two lines of attack against taxpayers claiming that state and local tax incentives can qualify for Sec. 118 treatment. First, the IRS analyzes these incentives under the tests established under CB&Q. These results would be similar to those previously discussed. Second, if the payment qualifies as a capital contribution under Sec. 118, the IRS then challenges whether reduction of an expense can qualify as a capital contribution.

In a CIP issued in 2008 (LMSB-04- 0408-023), the IRS concluded that a reduction to tax expense cannot constitute income under Sec. 61 because there was no right to receive any amount of income from the state, only a reduction to an expense. In support of this position, the IRS primarily cites the unpublished opinion in Snyder, 894 F.2d 1337 (6th Cir. 1990), vacating and remanding T.C. Memo. 1988-320, in which the IRS reversed its original position in Tax Court that tax reductions could constitute income to a taxpayer.

The IRS has continued to challenge any taxpayer that claims it can exclude state and local tax incentives from income under Sec. 118 and has raised the status to a Tier 1 examination issue. However, an internal IRS legal advice memorandum issued in 2008 (FAA 20085201F) comes to an interesting result surrounding refundable state tax credits. To the extent that a state tax credit is refundable and the credit actually exceeds tax due, the IRS has indicated that this credit could qualify as a contribution to capital under Sec. 118 if it otherwise meets the required tests.

Sec. 118 as a method of accounting: In Rev. Rul. 2008-30, the IRS indicated that an improper exclusion of a capital contribution from income under Sec. 118 and the related basis adjustment under Sec. 362(c) should be treated as a method of accounting. The IRS explains that the net impact of such an adjustment would net to zero over the life of a corporation. Therefore, a method change is required to correct improper Sec. 118 treatment. This finding is directly at odds with Saline Sewer Co., T.C. Memo. 1992- 236. In Saline Sewer, the Tax Court ruled that an improper exclusion from income under Sec. 118 and an improper adjustment to basis under Sec. 362(c) must be considered separately. As a result, the improper classifications become permanent, not temporary, items, requiring the amendment of prior-year tax returns. A district court decision, Florida Progress Corp., 56 F. Supp. 2d 1265 (M.D. Fla. 1998), followed the ruling of Saline Sewer, concluding that an exclusion from income under Sec. 118 and an improper adjustment to basis under Sec. 362(c) do not combine to result in a change in method of accounting.

In Rev. Rul. 2008-30, the IRS formally indicated that it does not acquiesce to the rulings in Saline Sewer or Florida Progress Corp. and will challenge any position to the contrary. In support of this position, the IRS included procedures to automatically change the method of accounting for items improperly treated under Sec. 118.


Frank O’Connell Jr. is a partner in Crowe Horwath LLP in Oak Brook, IL.

Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.

For additional information about these items, contact Mr. O’Connell at (630) 574-1619 or

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