Federal Income Tax Treatment of Certain Transferable State Tax Credits

Editor: Annette B. Smith, CPA

Gains & Losses

Taxpayers may receive state tax credits that for various reasons they are unable to use. These taxpayers often seek to sell their unwanted credits at a discount to generate additional cash and avoid losing the entire benefit of those credits. While in the past it has been somewhat difficult for motivated sellers to find interested buyers, the emergence of online marketplaces and auction houses has provided a single point of contact for both sellers and buyers, making sales and purchases of transferable state tax credits more common.

As a result, the IRS and the courts have begun to consider some of the federal income tax consequences associated with these transactions. In CCA 201147024, the IRS Office of Chief Counsel addressed the federal income tax treatment of certain transferable Massachusetts state tax credits.

Massachusetts Credits

Massachusetts offers a number of taxpayer incentives as a part of its economic development program. Some of these incentives are in the form of nonrefundable tax credits, including the brownfields tax credit, the motion picture tax credit (partially refundable), the historic rehabilitation tax credit, the low-income housing tax credit, and the medical device tax credit. Each credit is transferable in accordance with Massachusetts state law.

Issues Addressed in CCA 201147024

Is the original receipt of the state tax credit a taxable event? While gross income generally includes income from all sources, the IRS explained that the original recipient of the state tax credit “is not viewed as having received property in a transaction that results in the realization of gross income.” Stated differently, the granting of the credit is not treated as equivalent to a payment of cash or other property, and the amount of the credit is not included in gross income under Sec. 61. Under the CCA, the credit is treated as a potential reduction in the state tax liability. As a result, the federal income tax effect of such a credit normally is to reduce any deduction for payment of state tax that otherwise may have been available under Sec. 164(a).

What is the basis of the state tax credit to the original recipient? Sec. 1012 generally provides that the tax basis of property is the cost of the property. Regs. Sec. 1.1012-1(a) defines “cost” as the amount paid for the property in cash or other property. Since the state tax credit is obtained by complying with state law and is not acquired by purchase, the CCA concludes that the original recipient generally has no tax basis in the credit.

Is the subsequent sale of the state tax credit by the original recipient a taxable event? Citing Tempel, 136 T.C. 341 (2011), the CCA stated that when a transferable state tax credit subsequently is sold by the original recipient to another taxpayer for cash or other property, the transaction is a taxable sale for purposes of Sec. 1001. To the extent the original recipient has no tax basis in the credit sold, gain equal to the sales price is recognized.

Does the subsequent sale of the state tax credit by the original recipient result in capital gain or ordinary income? Relying largely on Tempel, the CCA concluded that a nonrefundable state tax credit is a capital asset to the extent it does not fall within any of the statutory exclusions in Sec. 1221(a).

In Tempel, the taxpayers sold excess transferable conservation easement tax credits granted by the state of Colorado to an unrelated taxpayer and treated the sales proceeds as capital gains. While the IRS conceded that the credits did not fall within any of the statutory exclusions set forth in Sec. 1221(a), it argued that the sales proceeds nevertheless should be treated as ordinary income under Gillette Motor Transport, Inc., 364 U.S. 130 (1960), and the multifactor test outlined in Gladden, 112 T.C. 209 (1999).

The Tax Court disagreed with the IRS, reasoning that the multifactor analysis applied in cases such as Gladden is relevant only to the analysis of contract rights and that a government-granted right to a tax credit is not a contract right. The Tax Court also held that the proceeds received from the sale were not a substitute for ordinary income. As a result, the taxpayers received capital gain treatment upon sale of their credits. However, since the taxpayers sold their credits in the same month in which they received them, the gains were short-term capital gains.

While the CCA disagreed with the Tax Court’s reasoning in Tempel that the multifactor analysis should not apply unless there are contract rights at issue, it accepted the Tax Court’s conclusion. Accordingly, the CCA agreed that upon sale of one of the nonrefundable Massachusetts state tax credits described above, the taxpayer would recognize a capital gain unless the credit were to fall within one of the statutory exclusions outlined in Sec. 1221(a). The CCA did not take a position on whether the sale of a partially refundable credit, such as the Massachusetts motion picture tax credit, would result in capital gain or ordinary income. Instead, it reserved the right to review the facts of a specific taxpayer’s actual sale of that credit before expressing an opinion.

What is the purchaser’s tax basis in the state tax credit upon sale by the original recipient? As noted above, Sec. 1012 generally provides that the tax basis of property is the cost of the property, and Regs. Sec. 1.1012-1(a) defines “cost” as the amount paid for the property in cash or other property. Accordingly, the CCA explained that the purchaser’s tax basis in the acquired state tax credit (which was referred to as a “valuable right”) is equal to the consideration paid. It further stated that any transaction costs incurred in connection with acquiring the credit also are includible in the purchaser’s tax basis unless they qualify as de minimis costs under Regs. Sec. 1.263(a)-4(e)(4)(iii).

Should the purchaser recognize gain if the original recipient sells the state tax credit at a discount; if so, when should the purchaser recognize the gain? The CCA stated that the use of the state tax credit to satisfy the purchaser’s state tax liability is a transfer of property to the state in satisfaction of the liability, not a reduction in the liability. Accordingly, in the year the purchaser uses the credit to satisfy its tax liability, the purchaser will recognize gain under Sec. 1001 equal to the difference between the liability satisfied and the tax basis of the credit under Sec. 1011. In addition, the purchaser will be deemed to have made a payment of state tax for purposes of Sec. 164(a).

For example, if the purchaser pays $80 for a credit that has a “face value” of $100 in year 1 and uses half of the credit to satisfy its $50 state tax liability in year 2, the purchaser would allocate $40 of the $80 tax basis to the credit used, pursuant to Regs. Sec. 1.61-6(a), and recognize a gain in the amount of $10 in year 2. In addition, the purchaser would be deemed to have made a payment of state tax in the amount of $50 for purposes of Sec. 164(a).

In the above example, it should be emphasized that gain to the purchaser is recognized as the credit is used, not when the credit is purchased. Similarly, it is the use of the previously purchased credit that triggers the deemed payment of state tax for purposes of Sec. 164(a), not the purchase of the credit itself.

Observations

Taxpayers that are unable to use existing state tax credits may consider selling them at a discount to generate additional cash and avoid losing the entire benefit of those credits. Taxpayers that could use additional state tax credits may consider purchasing them at a discount to reduce their overall tax liability. While sellers may be content to receive a smaller benefit in connection with a sale of state tax credits (since absent a sale, they otherwise would have received no benefit from the credits), purchasers of credits should ensure that the discounted price to be paid for the credits results in an acceptable rate of return when compared with other investment alternatives.

Whether selling or purchasing state tax credits, taxpayers should understand the terms and conditions associated with the transfer of those credits and properly account for the related federal income tax consequences, including the timing, extent, and character of any gain or loss.

EditorNotes

Annette Smith is a partner with PwC, Washington National Tax Services, in Washington, D.C.

For additional information about these items, contact Ms. Smith at 202-414-1048 or annette.smith@us.pwc.com.

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