Telecom Universal Service Fund Payments Not Excludible from Income Under Sec. 118

By Carol Conjura, J.D., CPA, and Michael Mehanna, CPA, Washington, DC

Editor: Mary Van Leuven, J.D., LL.M.

Gross Income

Federal and state governmental entities sometimes make Universal Service Fund (USF) payments to telecommunications carriers for providing telephone and communication services to low-income users and those users in remote or isolated areas where such services are not as readily available and are more expensive. The courts have recently addressed the tax treatment of those payments.

On January 4, 2011, in AT&T, Inc., 629 F.3d 505 (5th Cir. 2011), the Fifth Circuit affirmed the district court’s ruling that USF payments received by AT&T from various federal and state government entities were not excludible from gross income as nonshareholder contributions to capital under Sec. 118. The district court had granted summary judgment to the government, finding there to be no genuine issue of material fact as to whether the payments were intended to subsidize revenue rather than capital (AT&T Inc., No. SA-07-CV-0197 OG (W.D. Tex. 5/4/09)). On appeal to the Fifth Circuit, the taxpayer had argued that the district court erred by failing to apply a five-factor test established by the Supreme Court. The Fifth Circuit agreed with the result reached by the district court but applied both the district court’s test and the five-factor test.

Sec. 118

Generally, any contribution of money or property made to the capital of a corporate taxpayer by a shareholder or nonshareholder is excluded from the recipient’s income under Sec. 118. Given the absence of guidance in the statute and regulations, the relevant criteria for determining whether a nonshareholder payment is excludible have been developed in the courts, including the Supreme Court on several occasions. In some early decisions, the courts applied a functional use test that focused on the recipient’s use of the funds, but subsequent courts have generally applied a more subjective test that focuses on the contributor’s motive for the contribution. In Chicago, Burlington & Quincy R.R. Co., 412 U.S. 401 (1973) (CB&Q), the Supreme Court set forth five factors—at least four of which must ordinarily be satisfied before a court could conclude that the contributor’s motive was to make a capital contribution:

  • The contribution must become a permanent part of the transferee’s working capital structure;
  • The contribution must not be compensation, such as a direct payment for a specific, quantifiable service provided for the transferor by the transferee;
  • The contribution 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, must be employed in or contributed to the production of additional income and its value assured in that respect.
The Fifth Circuit’s Reasoning

At issue in AT&T were the payments under the USF’s high-cost and low-income support programs, which are designed mainly to provide affordable telephone service to consumers in high-cost rural or isolated areas. The district court rejected AT&T’s plea to apply the CB&Q five-factor test and instead concluded that it could discern the contributor’s intent by examining the government’s method for making the payments. Even though acknowledging that a carrier’s capital improvements undoubtedly affect the amount of payments it received, the district court concluded that the calculation of the payments focuses on revenue as opposed to capital improvements because the payments effectively reimburse the carrier for providing discounted services.

The Fifth Circuit, as an appellate court, was entitled to affirm the district court’s judgment on “any ground supported in the record” (Lee v. Kemna, 534 U.S. 362, 391 (2002)). After applying the CB&Q test, the Fifth Circuit reached the same conclusion as the district court. It also agreed with the district court that the intent of a government contributor could be gleaned from the authorizing laws or regulations and that the district court’s interpretation of the USF program was supported by the record. Thus, it did not decide whether one method was more appropriate or required as a matter of law.

The Fifth Circuit’s application of the CB&Q test led it to conclude the following:

  • AT&T’s involvement in the structure of the USF program, including lobbying and advocacy, was not enough to render the payments “bargained for” by AT&T;
  • The payments were compensation to AT&T for providing specific, quantifiable services, observing that the USF draws money from carrier assessments, which are passed on to customers; and
  • The payments did not become a permanent part of AT&T’s capital because they were not made exclusively for new capital improvements.
Analysis and Implications

Regarding the Fifth Circuit’s conclusion that the payments were not bargained for on the basis of AT&T’s involvement in the structure, the opinion discusses the fact that the USF program was intended to induce carriers to make the necessary investments to serve high-cost customers and thus incur the incremental cost of providing such services. The carriers arguably bargain for the payments because they have to become eligible for the payments rather than being passive subjects of the program. The Fifth Circuit’s reasoning for why the payments were for specific, quantifiable services would seemingly render the government a customer in almost every case when the direct customers of the contribution’s recipient are taxpayers of the government contributor.

The Fifth Circuit’s interpretation of the first CB&Q factor requiring that the payments be exclusively for new capital improvements is significantly more restrictive than some courts have allowed in other contexts. In discerning the contributor’s motivation apart from the CB&Q test, both the district court and the Fifth Circuit found there was no genuine issue of material fact, despite being presented with an extremely fact-intensive and legally complex case with heavily disputed facts. Congress’s intent for the USF program, as enacted by the Telecommunications Act of 1996, P.L. 104-104, is spelled out in 47 U.S.C. Section 254(e) as follows:

Universal Service Support—After the date on which Commission regulations implementing this section take effect, only an eligible telecommunications carrier designated under section 214(e) of this title shall be eligible to receive specific Federal universal service support. A carrier that receives such support shall use that support only for the provision, maintenance, and upgrading of facilities and services for which the support is intended. Any such support should be explicit and sufficient to achieve the purposes of this section.

In addition, the Fifth Circuit observed many times that the USF payments were designed to offset the companies’ added costs of servicing the target customers, yet it ultimately characterized the payments as a revenue subsidy. To the extent the payments are related to added costs—although they might be viewed as reimbursing a carrier for providing “discounted” services—the payments would seem equally, if not more so, to be defraying the incremental cost of providing more costly services. The regulatory scheme links the payments directly to the taxpayer’s costs and not to a revenue shortfall (as was the case in Detroit Edison Co., 319 U.S. 98 (1943)).

In reaching their decisions, both the district court and the Fifth Circuit concurred with the reasoning in Coastal Utilities, Inc., 483 F. Supp. 2d 1232 (S.D. Ga. 2007), aff’d per curiam 514 F.3d 1184 (11th Cir. 2008), in which another district court held that similar USF payments made to a rural telephone company were not contributions to capital under Sec. 118.

In Sprint Nextel Corp., No. 09-2325-KHV/JPO (D. Kan. 3/4/11), another district court, applying similar reasoning, granted the government’s motion for summary judgment in a refund suit regarding similar types of USF payments. If appealed, this case would go before yet another federal circuit court of appeals—this time the Eighth Circuit.

The IRS’s stance with respect to the USF payments is in contrast to Rev. Proc. 2010-34, in which the IRS provided a safe harbor for the treatment of payments made to carriers under the Broadband Technology Opportunities Program (BTOP) enacted by the American Recovery and Reinvestment Act of 2009, P.L. 111-5. Rev. Proc. 2010-34 provides that the IRS will not challenge the treatment of payments made through the BTOP as nonshareholder contributions to capital under Sec. 118 if the corporation properly reduces the basis of the property under Sec. 362(c)(2) and the regulations thereunder. Rev. Proc. 2010-34 provides a safe harbor, rather than a ruling on the IRS’s legal interpretation of Sec. 118, and thus does not articulate any basis for a meaningful comparison to USF payments.

Tier I Issue

The IRS Large Business and International Division (LB&I; formerly Large and Mid-Size Business Division) issued Industry Director Directive No. 1 on December 28, 2006 (LMSB-04-1106-016), placing Sec. 118 transactions on their list of Tier I issues. The Tier I designation effectively makes all Sec. 118 transactions a mandatory examination item.

Furthermore, on April 2, 2007, Industry Director Directive No. 2 was issued (LMSB-04-0307-026), specifically focusing on the sub-issue of USFs and whether amounts received by telecommunications providers from federal and state universal service programs constitute taxable income under Sec. 61 or nonshareholder contributions to capital excludible from income under Sec. 118. The publication of Directive No. 6 (LMSB 4-0209-003) reduced that sub-issue from an active Tier I issue to monitoring status; however, it still remains a coordinated issue of the LB&I.


While setting a precedent for a restrictive application of Sec. 118, both the district court and the Fifth Circuit stopped short of concluding that the USF payments in all cases would be fully taxable as a matter of law, but instead determined that AT&T had not met the required burden of proof. As a result, both courts left open the possibility that they might permit a taxpayer in an analogous case to offer evidence that, under its particular facts, it would not have been eligible for the payments without having invested in new capital improvements, in whole or in part. In this regard, in G.M. Trading Corp., 121 F.3d 977 (5th Cir. 1997), the Fifth Circuit held that payments only part of which qualified under Sec. 118 could be apportioned between Sec. 118 contributions to capital and Sec. 61 taxable income. Although affirming the district court on the particular facts in AT&T, one interpretation of the Fifth Circuit’s conclusion is that the CB&Q test need not be rigidly applied to ascertain the contributor’s motive. This could prove helpful in some cases when the taxpayer might have difficulty meeting four of the five tests and other evidence points away from the payment’s being a revenue subsidy.


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

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

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