State and local governments have long used a variety of incentives to entice corporations to relocate or expand operations in their jurisdictions. In exchange for the expected creation of new jobs, incentive packages typically provide financial assistance in the form of tax credits, tax exemptions, cash grants, loans, land, equipment, or infrastructure development. Before the enactment of P.L. 115-97, the law known as the Tax Cuts and Jobs Act (TCJA), these incentives were not likely to be considered income for their recipients under the Internal Revenue Code. They were, instead, generally considered contributions to capital. Since the passage of the TCJA, however, states and businesses can no longer make this assumption. Some of these incentives will now likely be income to the recipient corporation, while others will be unaffected.
New direction on contributions to capital
Signed into law by President Donald Trump on Dec. 22, 2017, the TCJA makes sweeping changes to the Code, including an amendment to Sec. 118, which concerns contributions to the capital of a corporation. The general rule of Sec. 118, set forth in subsection (a), was kept in place: "In the case of a corporation, gross income does not include any contribution to the capital of the taxpayer." As amended by the TCJA, however, a new exception is added in subsection (b)(2): the term "contribution to the capital of the taxpayer" does not include "any contribution by any governmental entity or civic group (other than a contribution made by a shareholder as such)."
This change specifically targets state and local incentives. The prior version of Sec. 118 made no mention of contributions by governmental entities and civic groups. The now-out-of-date regulation for Sec. 118 illustrated the application of the old rule: If a corporation required additional funds for conducting its business and obtained those funds from payments by its shareholders, the amounts received were excluded from gross income (Regs. Sec. 1.118-1). The exclusion also applied 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" (id.). But under the amended Sec. 118, these incentives are no longer considered contributions to capital and must be included in gross income.
The legislative history of the TCJA provides insight into Congress's motivation for the amendment. The House Ways and Means Committee's report for the bill explained that:
treating contributions to capital by nonshareholders as income to the corporation will remove a Federal tax subsidy for State and local governments to offer incentives to businesses as a way of encouraging them to locate operations in a particular jurisdiction. If taxpayers in a particular State or locality wish to provide such financial inducements to businesses, they should be able to do so, but they should bear the cost of such financial inducements without passing on a portion of those costs to all Federal taxpayers. [H.R. Rep't No. 115-409, 115th Cong., 1st Sess., p. 256 (Nov. 13, 2017)]
The House version of the bill had originally proposed to repeal Sec. 118 and replace it with a new Sec. 76. This new section would have provided that gross income includes any contribution to the capital of any entity, except for contributions in exchange for stock or any other interest in an entity other than a corporation. The committee provided a couple of examples to show how the new law would be applied: "a contribution of municipal land by a municipality that is not in exchange for stock . . . is considered a contribution to capital that is includable in gross income. By contrast, a municipal tax abatement for locating a business in a particular municipality is not considered a contribution to capital" (id.).
While the bill's final version differs in particulars from the House bill, the conference committee report notes that the final version of the TCJA "follows the policy of the House bill but takes a different approach" (H.R. Conf. Rep't No. 115-466, 115th Cong., 1st Sess., p. 398 (Dec. 15, 2017)). The final version did not repeal Sec. 118 but instead provided the exception from the general rule of noninclusion for contributions by governmental entities or civic groups. The conference committee also stated that it intended for Sec. 118 to "continue to apply only to corporations," and that the amendment "applies to contributions made after the date of enactment. However, the provision shall not apply to any contribution made after the date of enactment by a governmental entity pursuant to a master development plan that has been approved prior to such date by a governmental entity" (id.).
Congress was aware that the amendment to Sec. 118 would likely affect a substantial number of incentives being offered by state and local governments. The Joint Committee on Taxation estimated that from 2018 through 2027, the amendment would result in $6.5 billion in additional revenue to the federal government (Joint Committee on Taxation, Estimated Budget Effects of the Conference Agreement for H.R. 1, the "Tax Cuts and Jobs Act," (JCX-67-17), p. 6 (Dec. 18, 2017)).
Despite the clarifying comments by the conference committee, several uncertainties surround the application of the revised Sec. 118. For example, the term "master development plan" is not defined in the statute, and questions may arise about the requirements for a plan to pass muster as a master development plan. This is especially important for incentive agreements that were approved before the passage of the 2017 tax law but not fully implemented. It is not unusual for these agreements to require businesses to meet specific milestones to receive their benefits, such as hiring a certain number of employees by a certain date.
Businesses may also be concerned about whether a statutory incentive program can qualify as a master development plan. A state may have approved a business to receive incentives over the course of a number of years, assuming that the business meets ongoing statutory requirements, such as providing its employees with health insurance and paying them a minimum average wage. In these situations, are the incentives due to be paid in future years now subject to inclusion in income?
Because Sec. 118 and its legislative history materials are silent on this question, Treasury and the IRS may need to provide some official guidance in the near future. In the meantime, at least one jurisdiction has attempted to address this uncertainty through new legislation. The District of Columbia's Master Development Plan Recognition Temporary Act of 2018 (D.C. Act 22-245 (Jan. 9, 2018)) cites numerous projects and plans that have been previously approved by the District and recognizes them as master development plans. Whether Treasury and the IRS would agree remains to be seen.
Types of incentives that might be included in gross income
As noted, the committee reports included two examples of the application of the amendment to incentives provided by a municipality (representing all governmental entities). A contribution of land by a municipality not in exchange for the stock of a corporation would be included in the corporation's gross income, but a tax abatement provided by a municipality to a corporation would not be included. According to the online State Business Incentives Database maintained by the Council for Community and Economic Research, the most popular incentives provided by states are tax credits, grants, loans, and tax exemptions. Of these categories, the amendment to Sec. 118 likely affects only the taxability of grants, but this category could encompass a fairly broad range of incentives.
The general rule to determine whether a transfer of money or property is subject to inclusion in income comes from Sec. 61, which defines "gross income" as "all income from whatever source derived." The statute lists 14 illustrative examples, such as gross income derived from business, gains derived from dealings in property, and income from discharge of indebtedness. In addition, the U.S. Supreme Court has defined income as "instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion" (Glenshaw Glass Co., 348 U.S. 426, 431 (1955)).
Based on these definitions, loans provided by states or localities are not considered gross income and are not affected by the amendment to Sec. 118. Loan proceeds that must be repaid are not accessions to wealth because of the offsetting liability (see, e.g., Tufts, 461 U.S. 300 (1983)).
Tax exemptions are also not considered "gross income" under the law. The municipal tax abatement used in the example in the committee report as a nonincludible item can also be considered a tax exemption. Regardless of the terminology used, it is well-settled that a reduction in a tax liability is not an accession to wealth and is therefore not income (Tempel, 136 T.C. 341 (2011)).
Similar to tax exemptions, state tax credits should generally not be included in income, although there are a few exceptions. Some tax credits are refundable, meaning that taxpayers can receive refunds after reducing their state tax liabilities. The excess portion that remains after reducing the state tax liability must be included in gross income (Maines, 144 T.C. 123 (2015)).
Another exception pertains to the sale of tax credits. When sold, credits are deemed to be capital assets, and gains on their sale are taxable at capital gain rates (Tempel, 136 T.C. at 355). Finally, under the tax benefit rule, tax credits may also be considered gross income if they offset tax previously paid for which a federal income tax deduction was claimed (Maines, 144 T.C. at 129). It should be noted that these rules existed before the amendment to Sec. 118, and it does not appear that they would be affected by the new law.
On the other hand, grants provided as incentives are now likely required to be included in gross income under the amended Sec. 118. Grants can take the form of any cash, real property, or tangible personal property provided to a taxpayer without the expectation of repayment. These grants could be provided upfront, as reimbursement of documented expenses, or based on achieving specific project milestones. The committee reports used the example of a municipality's transfer of land not in exchange for stock as a transfer that would now be deemed includible. Another example of a grant would be cash the taxpayer provided to match employee training expenses the taxpayer incurred. Many states also provide cash grants as a "deal-closing incentive," particularly when there is sharp competition for a business's site selection. Under the amendment, these cash grants would be includible in income as well.
A category of grants might not be includible in certain situations — infrastructure improvements, such as improved access to a specific site. These incentives could arguably benefit not only the taxpayer, but also the general public. Therefore, the taxpayer may lack the "complete dominion" over the property as required by the Supreme Court's definition of "income" set forth above. This is another area of uncertainty that may need to be sorted out over time.
Shifting incentive strategies
State and local governments use grants widely as economic development and site location incentives. Some examples of state economic development grant programs include the Michigan Business Development Program, Florida's Quick Action Closing Fund, the Arizona Competes Fund, and the Texas Enterprise Fund. Because the amendment to Sec. 118 will require businesses to include in gross income the value of money or property received as grants, these incentives may be affected. Without a doubt, the revision to Sec. 118 will alter the use of certain types of incentives and will cause all parties to carefully tailor incentive strategies to their specific needs.
These articles represent the views of the author(s) only, and do 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.
Mary Van Leuven is a director, Washington National Tax, at KPMG LLP in Washington.
For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or email@example.com.
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