The IRS has released Letter Ruling 201003005, which concludes that (1) nonreimbursable payments from the government to a corporate taxpayer to construct a plant are nonshareholder contributions to the capital of the taxpayer under Sec. 118(a) and are excluded from the taxpayer’s gross income under Sec. 61, and (2) the basis of the plant’s capital assets acquired by the taxpayer with the money contributed by the government is reduced according to Sec. 362(c).
Although the letter ruling is based on a specific fact pattern and is not to be cited as precedent, it may help federal and state stimulus program grant recipients determine whether those payments potentially qualify as excludible nonshareholder contributions to capital. This item summarizes the letter ruling and other relevant legal authorities and IRS guidance that may be helpful in making that decision.
Taxpayer Facts and Request
The taxpayer is a wholly owned corporate subsidiary that entered into an agreement with the government in which the government will make payments to assist the taxpayer in construction of a plant under a government program. The taxpayer will receive the program awards during the design, permitting, equipment procurement, construction, and start-up phases of the plant as well as the project demonstration period.
The taxpayer requested the following rulings:
- The payments from the government to the taxpayer under the program for the plant are a nonshareholder contribution to the taxpayer’s capital under Sec. 118(a) and are thus excluded from the taxpayer’s gross income under Sec. 61; and
- The basis of the plant’s capital assets acquired by the taxpayer with the money from the program contributed by the government shall be reduced in accordance with the provisions of Sec. 362(c) and the regulations thereunder.
Relevant Legal Authorities
Sec. 61(a) provides that except as otherwise provided in Subtitle A (Income Taxes), “gross income” means all income from whatever source derived. Regs. Sec. 1.61-1(a) defines gross income as all income from whatever source derived, unless excluded by law. Gross income includes income realized in any form, whether money, property, or services.
Sec. 118(a) excludes any contribution to the capital of a corporation from gross income. Regs. Sec. 1.118-1 applies the Sec. 118 exclusion to contributions to capital made by persons other than shareholders. For example, the exclusion applies to the value of land or other property contributed to a corporation by a government 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 facilities.
In Chicago, Burlington & Quincy R.R. Co., 412 U.S. 401 (1973), the Supreme Court, in determining whether a taxpayer was entitled to depreciate the cost of certain facilities that had been funded by the federal government, held that the governmental subsidies were not contributions to the taxpayer’s capital. The court discussed the findings in Brown Shoe Co., 339 U.S. 583 (1950), and Detroit Edison Co., 319 U.S. 98 (1943), and established a list of characteristics of a nonshareholder contribution to capital:
- The asset must become a permanent part of the transferee’s working capital structure;
- It may not be compensation, such as a direct payment for a specific, quantifiable service provided for the transferor by the transferee;
- It must be bargained for;
- The asset transferred foreseeably must result in benefit to the transferee in an amount commensurate with its value; and
- The asset ordinarily, if not always, will be employed in or contribute to the production of additional income and its value assured in that respect.
The IRS determined that the fact pattern discussed in the letter ruling met the requirements of Chicago, Burlington & Quincy R.R.
Sec. 362(c)(2) addresses the basis consequence if a nonshareholder, such as the government, contributes money to a corporation’s capital. Sec. 362(c)(2) provides that, notwithstanding Sec. 362(a)(2) (providing generally a transferred basis for contributions by shareholders), if a corporation receives money from a nonshareholder as a contribution to capital, the basis of any property acquired with that money during the 12-month period beginning on the day the contribution is received shall be reduced by the amount of the contribution. The excess (if any) of the amount of the contribution over the amount of the basis reduction of property acquired during this 12-month period shall be applied (as of the last day of the 12-month period specified in the preceding sentence) to further reduce the basis of any other property held by the taxpayer. The particular properties to which the taxpayer must allocate the reductions are determined under Regs. Sec. 1.362-2.
In Letter Ruling 201003005, the IRS concluded that the taxpayer should take the basis reduction with respect to the plant, presumably because the taxpayer received the money as a direct result of its investment in the plant. The ruling does not discuss whether the basis reduction should be pro rata with respect to all plant assets or to specific plant assets. This issue could make a significant timing difference if different depreciation recovery periods apply to different components of the plant.
Sec. 118 Contributions to Capital: A Tier I Issue
Whether income qualifies as a nonshareholder contribution to capital under Sec. 118 has been an IRS Tier I issue since 2006, and the IRS has issued eight industry director directives in this regard.
While most of the directives focus on industry issues such as specific reimbursement programs, one that is relevant to the treatment of government grants, such as those in Letter Ruling 201003005, specifically addresses nonrefundable state and local tax incentives (LMSB-4-0608-034). This directive discusses certain corporate tax strategies that taxpayers may be attempting regarding these receipts. All taxpayers should review the directive before determining proper federal income tax treatment of government grants. The directive states that the IRS’s position is that state and local tax incentives (other than refundable credits) are not income under Sec. 61 and do not give rise to additional deductions under Secs. 164 or 461. State and local tax incentives are reductions in liability, according to the directive, and the only deduction allowed by the Code is the net liability due and payable after application of the incentive.
Potential Implications of the Letter Ruling
Letter Ruling 201003005 comes at a time when many taxpayers are receiving or have recently received federal and state funds through certain government stimulus programs and should be evaluating whether or not the payments qualify under Sec. 118. Taxpayers may have an opportunity under Sec. 118 to treat the amounts received from certain stimulus programs as nonshareholder contributions to capital and therefore avoid paying current federal income tax on such amounts. However, in some fact patterns, taxpayers may not be able to satisfy the requirements for eligibility under Sec. 118. A thorough review of the terms and conditions of the grant is necessary to determine the appropriate federal income tax treatment. Consideration should also be given to whether the taxpayer’s state and local jurisdictions conform with Sec. 118 for income tax purposes.
In addition to the industry directive mentioned above, in 2008 the IRS issued a coordinated issue paper on state and local location tax incentives (LMSB-04-0408-023). The guidance focuses on nonrefundable state incentives in the form of abatements, credits, deductions, rate reductions, or exemptions and concludes that those incentives do not otherwise give rise to gross income under Sec. 61; therefore, they do not qualify for exclusion under Sec. 118. However, in Letter Ruling 200910018 the IRS granted Sec. 118 treatment to state relocation grants received by a taxpayer. In that situation, the grants were refundable, and the taxpayer used them to expand its business by establishing a facility in a specified location. The grants were determined to have met all requirements of Chicago, Burlington & Quincy R.R. and to have qualified for Sec. 118 treatment.
Another key consideration is that Sec. 118(a) applies only to corporations; therefore, exclusion of stimulus grants would not be available to a business operated in partnership form for federal tax purposes, although it would apply to an S corporation. As a result, a partnership that expects to receive grants or similar incentives that might otherwise be eligible for Sec. 118 treatment should examine the feasibility of negotiating to have the government grantor provide the grant to a corporate owner, if any, with respect to its investment in the partnership.
Automatic Accounting Method Change Is Available
The recent guidance may have taxpayers reassessing whether Sec. 118 applies to any payments they have received from a nonshareholder and could present either an opportunity or an exposure area that may require an accounting method change. A taxpayer may file an automatic Form 3115, Application for Change in Method of Accounting, under Rev. Proc. 2008-52 to change its method of accounting under Sec. 118 with respect to nonshareholder contributions to capital. However, as modified by Rev. Proc. 2009-39, Rev. Proc. 2008-52 generally limits the automatic procedure to when the taxpayer is changing from treating amounts as excludible under Sec. 118 to treating them as current gross income. For any change in the treatment of amounts received in prior years from taxable to excludible under Sec. 118, a taxpayer must request advance consent under Rev. Proc. 97-27. If the taxpayer is receiving a particular type of grant for the first time in the current year, the taxpayer would be adopting a method of accounting and would not need to follow either the automatic or the nonautomatic consent procedures.
Editor: Mary Van Leuven, J.D., LL.M.
Mary Van Leuven is Senior Manager, Washington National Tax, at KPMG LLP in Washington, DC.
For additional information about these items, contact Ms. Van Leuven at (202) 533-4750 or firstname.lastname@example.org.
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This article represents the views of the author or authors only and does not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.