Editor: Annette B. Smith, CPA
Corporations & Shareholders
Corporations often negotiate various incentives from state and local governmental units or civic groups, for example, when seeking to relocate or enter a community. In exchange for meeting certain requirements—e.g., building a factory or expanding existing infrastructure, operating in the community for a period of time, and employing a specified number of employees—a corporation may receive cash, land, or other property.
At first glance, it is not immediately apparent how these transfers should be treated for tax purposes. On the one hand, such incentives may be viewed as not intending to benefit the government or civic group in such a direct way as to be considered a payment for future services or goods. This view seems consistent with treating the transfers as nontaxable gifts. On the other hand, the incentives may be viewed as extended with the expectation of some benefit to the government or civic group, namely, the indirect benefit to the public good or community at large. This view suggests treatment of the transfers as taxable receipts for the payment of goods or services.
The conclusion reached in court decisions and ultimately confirmed by Congress in enacting Sec. 118 is that transfers made to corporations in which the only benefit received is some indirect public good generally should be treated as nonshareholder capital contributions excludable from gross income. While this is the general rule, the terms under which a particular transfer is made can and do affect the tax treatment of the transfer.
Judicial precedent provides insight into what conditions must be met to classify transfers as nonshareholder capital contributions. One consideration courts have raised is the question of a jobs requirement—that is, requiring the corporation to employ a specified number of employees for a specified period of time. Given the ruling (discussed below) in Brown Shoe Co., 339 U.S. 583 (1950), imposition of a jobs requirement should not by itself prevent a subsidy from qualifying as a nonshareholder contribution.
History of Sec. 118
Sec. 118 provides that “[i]n the case of a corporation, gross income does not include any contribution to the capital of the taxpayer.” The regulations provide guidance regarding nonshareholder contributions, stating (by way of example) 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” (Regs. Sec. 1.118-1). The regulations clarify that “the exclusion does not apply to any money or property transferred to the corporation in consideration for goods or services rendered, or to subsidies paid for the purpose of inducing the taxpayer to limit production” (Regs. Sec. 1.118-1).
The 1954 legislative history of Sec. 118 indicates that enactment of the Code section “merely restates the existing law as developed through administration and court decisions” (H.R. Rep’t No. 1337, 83d Cong., 2d Sess., A38 (1954)). Accordingly, taxpayers generally look to judicial precedents for guidance. The Supreme Court cases often cited are Detroit Edison Co., 319 U.S. 98 (1943), Brown Shoe Co., 339 U.S. 583 (1950), and Chicago, Burlington & Quincy Railroad Co., 412 U.S. 401 (1973).
In Detroit Edison, customers who were beyond the utility’s electrical infrastructure could pay the utility to cover the cost of extending the infrastructure to them. The Supreme Court ruled that these amounts in effect were payments for services and denied the company’s claim to treat the payments as nonshareholder capital contributions. In Brown Shoe, community groups made contributions to the corporation to build and expand manufacturing facilities in the area. Contrary to Detroit Edison, the court affirmed the company’s claim of a nonshareholder contribution, reasoning that the transfers were not direct payments for services. The 1973 opinion in Chicago, Burlington & Quincy Railroad Co. helped clarify the Supreme Court’s position by outlining five characteristics to be considered in testing the motive and intent of the transferor when determining if a transfer meets the requirements for being considered a nonshareholder contribution to capital. The contribution must:
- Become a permanent part of working capital;
- Not be compensation for specific quantifiable services;
- Be bargained for;
- Provide a foreseeable benefit to the corporation in an amount commensurate with its value; and
- Ordinarily be employed to generate additional income.
Corporations sometimes receive incentives conditioned on building new or expanding existing facilities and employing a stipulated number of employees in those facilities. Taxpayers might conclude that a jobs requirement may cause an incentive to be characterized as a taxable payment in return for future services.
Brown Shoe would not support this conclusion. In that case, the taxpayer received cash and two factory buildings from 12 community groups; in nearly every instance, the taxpayer and the community group entered into a contract. The general terms of each contract required the taxpayer to construct a new factory or to enlarge an existing one in the particular community; to operate it for an agreed period of time, usually 10 years; to employ a stipulated number of employees; and to meet a minimum stipulated payroll during the period agreed upon.
The Supreme Court found that
the contributions to petitioner were provided by citizens of the respective communities who neither sought nor could have anticipated any direct service or recompense whatever, their only expectation being that such contributions might prove advantageous to the community at large. Under these circumstances the transfers manifested a definite purpose to enlarge the working capital of the company. [Brown Shoe, 339 U.S. at 591]
Thus, in Brown Shoe, the jobs requirement did not preclude the taxpayer from treating the incentives as nonshareholder contributions to capital excludable from income.
In seeming contrast to the Supreme Court holding in Brown Shoe is recently issued IRS Field Attorney Advice (FAA) 20124103F. In this FAA, a corporate taxpayer received a loan from a state government in exchange for making certain capital improvements and retaining and creating a specified number of jobs. The loan, according to its terms, was to be wholly or partially canceled at the end of a specified term, depending on whether the taxpayer created a specified number of jobs during a specified period of time. The IRS found the cash incentive paid to the taxpayer to be a bona fide loan and concluded “[t]hat part of the principal not subject to repayment is an accession to wealth for the taxpayer and thus ordinary income. . . . The cancelled debt is not a capital contribution.” The IRS argued against characterizing the incentives as payments for services: “We know of no precedent for holding that a cash incentive to create jobs is the ‘purchase of services.’” At the same time, the IRS argued against treatment of the subsidy as a contribution of capital: “We believe that Sec. 118 does not apply, as the amount of debt to be cancelled depends on the number of employees hired and retained.” While the facts presented in the FAA do not specifically disclose whether the cancellation of debt was also dependent on capital investment in the facility, the overall conclusion of income inclusion appears to be in contrast to the conclusions reached by the Supreme Court in Brown Shoe. At the same time, FAA 20124103F may indicate current IRS thinking with respect to jobs requirements and the application of Sec. 118.
Corporations often receive various incentives from governmental units or civic groups. These payments generally may be treated as nonshareholder contributions, provided the transfers meet certain criteria the courts have established for demonstrating that the economic effect of these transactions is capital in nature. While current field advice may provide an unclear picture, Supreme Court authority supports the position that transfers made under agreements that include a job retention or creation requirement are not necessarily precluded from treatment as nonshareholder capital contributions.
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 email@example.com.
Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.