State and local agencies and authorities commonly attempt to spur real estate or business development in their territories by offering economic development funds to encourage businesses to locate in a specific spot. Across the country, many billions of dollars of economic development and other research and development funds are distributed each year.
Funded by taxpayer dollars, these contributions generally carry conditions that require the recipient to comply with certain requirements that are deemed to serve one or more public purposes. The most common goals of these contributions include (1) fostering additional employment in the targeted territory and (2) developing real estate or other capital assets that become part of the ad valorem tax base in that territory.
This article discusses the federal tax consequences for a business entity receiving economic development funds. These non-owner contributions to capital may be tax free in certain instances, depending on the structure of the business entity. Whether the recipient is organized as a corporation or, as is often the case in modern transactions, as a single-purpose bankruptcy remote entity taxable as a partnership, can make a tremendous difference in the analysis of the resulting tax implications. The article concludes by suggesting a couple of ways that a transaction can be structured to bring it within the exclusion.
The IRC Framework for Economic Development Fund Exclusions
As a general rule, all accessions to wealth are taxable income to the recipient. IRC § 61. Congress has included a special exception in IRC § 118(a), however, that “[i]n the case of a corporation, gross income does not include any contribution to the capital of the taxpayer.”
The IRS has interpreted this exclusion to apply not only to contributions made by the corporation’s own shareholders, but also to “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.” 26 C.F.R. § 1.118-1. But, although the exclusion is generally applicable to economic development funds, the IRS has taken the position that the exclusion applies only to contributions made to a corporation and not to entities taxable as a partnership. IRS, Industry Director Directive No. 1 on Section 118 Abuse (Dec. 28, 2006), www.irs.gov/Businesses/Partnerships/Industry-Director-Directive-%231-on-Section-118-Abuse.
An argument can be made that the IRS’s interpretation is too narrow and that, under the analyses used in the seminal case law, the exclusion should apply more generally. To assess the viability of such an argument, the following discussion takes a close look at the origins of the exclusion.
The Supreme Court’s Tests for Nonshareholder Contributions
In United States v. Chicago, Burlington & Quincy Railroad Co., 412 U.S. 401 (1973), the U.S. Supreme Court had to determine what types of payments would qualify as nonshareholder contributions to capital. At issue in Chicago was whether the funds a railroad received from the federal government for facilities at highway-railroad intersections were nonshareholder contributions to capital, which would allow the railroad to depreciate the costs and derive a tax deduction. In resolving the case, the Court articulated five tests (each considered below) that have become benchmarks for determining the excludability of nonshareholder contributions to capital.
The Court also discussed the importance of the motive of the transferor/contributor of capital. In doing so, it distinguished its earlier decisions in Detroit Edison Co. v. Commissioner, 319 U.S. 98 (1943), and Brown Shoe Co., Inc. v. Commissioner, 339 U.S. 583 (1950). In Detroit Edison, the contributions were made with an expectation that the funds would directly benefit the contributor, but in Brown Shoe the only expectation of the contributors was that the contributions might prove advantageous to the community at large. Because the Brown Shoe contributions were not made with the purpose of receiving a direct service or recompense, the Court found the funds transferred to be a contribution to capital and therefore excludable from the recipient taxpayer’s gross income.
The Court in Chicago did not rely on the basis of the contributors’ motivation, however. From Detroit Edison and Brown Shoe, the Court in Chicago also distilled the following five characteristics of nonshareholder contributions to capital:
- the contribution must become a permanent part of the transferee’s working capital structure;
- the contribution may 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 contribution must foreseeably result in a benefit to the transferee in an amount commensurate with its value; and
- the contribution ordinarily, if not always, will be employed in or contribute to the production of additional income, which will serve as a return on the capital contributed.
Additional facts must be considered to flesh out each of the elements. For example:
The contribution must become a permanent part of the transferee’s working capital structure. When funds are contributed to reimburse the costs of a development project, the funds often purchase assets that are long-term in nature in exchange for a long-term interest in an asset or entity. The taxpayer must document and be able to prove that the contribution resulted in additional funds to reimburse or add to the investment in a development.
The contribution may not be compensation, such as a direct payment for a specific quantifiable service provided to the contributor by the recipient. When funds are paid by a governmental agency or authority, the payments are often not for any specific, direct, or quantifiable services that an entity provides to the agency or authority. When the payments are made in furtherance of the purpose of the agency or authority, for example, to increase nonresidential real estate development, to foster growth and development of a state or locality, or for other purposes, no specific services are provided. This element also requires careful documentation and should be part of the resolution as other authorizing documents from the non-owner contributor.
The contributions should be bargained for. To obtain governmental funds, an entity usually must go through an application process and explain the use of its own funds before receiving any governmental funds. The agency or authority is not typically required to provide such funds to an entity, nor does the entity have any right to receive such funds. Often very specific criteria must be met, and funding the contribution usually involves a multi-layered administrative process.
The asset transferred must foreseeably benefit the transferee in an amount commensurate with its value. When an entity receives funds and devotes those funds to a long-term investment, such an investment usually produces income attributable to the investment and the entity benefits thereby. The production of revenue should be documented and traced to the grant, which can be done based on specific accounting and monitoring of the revenue generated by the contribution.
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. An entity that invests public funds usually derives income from its investment, and all income is ultimately received by the entity, which will produce a rate of return that can be both measured and documented.
Is the Corporate Form Critical to the Transaction?
The Court’s analysis of Detroit Edison and Brown Shoe is significant because both cases preceded enactment of IRC § 118, and the legislative history suggests that IRC § 118 was intended to codify the prior case law. H.R. Rep. No. 83-1337, at 17 (1954) (“This [section] in effect places in the code the court decisions on this subject.”). Throughout its detailed discussion of the elements to be distilled from Detroit Edison and Brown Shoe, however, at no point did the Supreme Court point to the nature of the entity itself as a critical factor. Indeed, at the time of enactment of these statutes, the law offered few alternatives to corporations in terms of choice of business entity.
From the 1920s through the 1950s, the available entities that could be used were limited to corporations, which had well-articulated statutes in a number of states, Delaware and New York being the most notable examples. A very few other business forms such as general partnerships and, in a few states, business trusts (which had, after the antitrust cases and legislation of the early 20th century, been largely relegated to special purposes) were the alternatives. Pass-through entity forms of organization such as partnerships were far more primitive, and state statutes governing these entities varied greatly. Corporations treated as pass-through entities did not become part of the statutory fabric until 1982, when Subchapter S was substantially revised and made part of the Internal Revenue Code of 1954.
Since that time, alternative business forms have proliferated, and today virtually all states have as basic organizational structures corporations (both C and S), limited liability companies, limited partnerships, limited liability partnerships, general partnerships, and business trusts, to name only the broadest categories. Although several of those entity choices did not exist when the Supreme Court decided Detroit Edison, the reasoning employed in those cases for corporations applies just as well to all of these entity forms.
In addition, from a choice of entity standpoint, the regulatory environment has changed since Detroit Edison and Brown were decided: the 1954 Internal Revenue Code was enacted; the Tax Reform Act of 1986 made pervasive changes in the treatment of various activities at the individual level and created active, portfolio, and passive income; and subsequent developments have occurred in choice of entity options. All these changes have expanded and liberalized the potential forms in which business can be conducted, and recent regulations have allowed taxpayers to select the tax treatment of the entities used to conduct business. Most importantly, the law has been structured in such a way that the active, portfolio, and passive income classifications curb most of the perceived abuses of the entities to shelter income that existed under prior law.
The tax policy embedded in many of these changes was, at least in part, a reaction to tax shelters that evolved in the 1960s and 1970s. These shelters allowed greater than one-to-one write-offs based on investments made by taxpayers that had no management interest in and no liability exposure over and above investments made in these tax shelters, which were often organized as partnerships to take advantage of the pass-through treatment afforded partnerships. This history of perceived abuses of the partnership tax treatment could well factor into the current IRS position on the analysis of IRC § 118 cases.
IRS Limitations on IRC § 118
In case law and private letter rulings, the IRS has argued for limitations on the permissible transferees or imposed additional requirements to allow exclusion of income under IRC § 118. In Federated Department Stores Inc. v. Commissioner, 426 F.2d 417 (6th Cir. 1970), for example, a shopping center developer gave both cash and real estate to a department store as an incentive for the department store to locate in a proposed shopping mall. The IRS argued that the contributions did not qualify for an IRC § 118 exclusion because the payments were motivated by the developer’s own financial interest; and the developer was not a governmental unit or civic group. In rejecting both arguments, the court looked to the legislative history regarding the purpose of IRC § 118:
[Section 118] deals with cases where a contribution is made to a corporation by a governmental unit, chamber of commerce, or other association of individuals having no proprietary interest in the corporation. In many such cases because the contributor expects to derive indirect benefits, the contribution cannot be called a gift; yet the anticipated future benefits may also be so intangible as to not warrant treating the contribution as a payment for future services.
Federated Dep’t Stores, 426 F.2d at 421 (citing S. Rep. No. 83-1522, reprinted in 1954 U.S.C.C.A.N. 4648). Based on this report, the court rejected the IRS’s contention that contributions could be made only by governmental units or civic groups. In addition, although the developer admittedly made the contributions with the expectation that the department store would promote the developer’s financial interests, the court concluded that “any benefit expected to be derived by [the developer] was so intangible as to not warrant treating its contribution as a payment to taxpayer for future services.” Id. at 421.
The U.S. Court of Appeals for the Eighth Circuit reached the same conclusion in May Department Stores, Inc. v. Commissioner, 519 F.2d 1154 (8th Cir. 1975), in which a shopping center developer made a similar offer of real estate to a department store as an incentive to locate on that site. As in Federated Department Stores, the court rejected the IRS’s arguments that the transfers were required to be from governmental entities and that the payments made were designed to benefit the transferor. The court found that contributions of land to taxpayers from unrelated parties were nontaxable contributions under IRC § 118.
In several early letter rulings, the IRS allowed contributions to partnerships to be excluded from income under IRC § 118. See PLRs 7950002 (Aug. 2, 1979); 8038037 (June 24, 1980). In 1982, the IRS issued a General Counsel Memorandum that took the position that IRC § 118 applies only to corporations; thus the exclusion was not available to a public utility operating in the form of a partnership. I.R.S. Gen. Couns. Mem. 38,944 (Dec. 13, 1982). This position was reaffirmed in 2006, through an Industry Director Directive that similarly focused on the plain language of the statute to conclude that “taxpayers operating in partnership form cannot benefit from the use of IRC § 118.” IRS, Industry Director Directive No. 1 on Section 118 Abuse (Dec. 28, 2006), www.irs.gov/Businesses/Partnerships/Industry-Director-Directive-%231-on-Section-118-Abuse; see also IRS, Industry Specialization Program Coordinated Issue, Exclusion of Income: Non-Corporate Entities and Contributions to Capital (Nov. 18, 2008) (relying not only on the express language of IRC § 118, but also stating that IRC § 118 “unambiguously indicates that Congress limited the scope of the statutory provisions to businesses operating in corporate form, because that is precisely what the preexisting case law addressed”).
In TAM 9032001, the IRS revoked a prior TAM and several private letter rulings and took the position that IRC § 118 does not apply to partnerships. In this author’s view, the IRS appears to have adopted the position that, because the statute says “corporation,” the exclusion is limited to corporations and no common law doctrine for noncorporate taxpayers exists under case law, whether decided before or after the enactment of IRC § 118.
In recent years, a variety of new entities, including limited liability partnerships and limited liability companies, have emerged and the question of whether non-owner contributions can be excluded from income has once again become relevant in the context of these entities, all of which are typically taxable as partnerships. Note that these entities share most, if not all, the characteristics of corporations.
Recently, the IRS has been unyielding in its policy of prohibiting partnerships from using the exclusion. In ruling requests, the IRS has denied the exclusion in fact patterns in which a corporation received non-owner contributions to capital that would otherwise pass the test articulated in the case law, when the investment made by the corporation was indirect. The IRS has taken the position that the ownership of a preferred interest in an entity taxed as a partnership did not benefit from the exclusion. This was so even though the preferred interest had a guaranteed income preference and included an option exercisable in the sole discretion of the corporation to redeem the amount invested on a dollar-for-dollar basis. The corporation had received a contribution from a governmental authority, and the five-part test was clearly met otherwise.
In discussions with the IRS, it is clear that the use of ownership interests in a partnership as the investment vehicle was the fatal flaw from the IRS’s perspective. The possibilities for creative structuring of transactions in which corporations received the non-owner contributions as part of an ongoing business conducted by an entity taxable as a partnership was clearly the problem that the IRS has targeted and is actively combatting. Two alternative structures that would result in direct ownership of underlying assets by the corporation were conceded by the IRS to be permissible structures. In the first, the corporation owns a tenancy-in-common interest in real estate. In the second, the partnership sells some interest in the real estate in conjunction with a leaseback, by the partnership from the corporation.
The IRS is clearly endeavoring to stem the tide of creative structuring of transactions in which corporations and partnerships are part of transactions in which a corporation receives non-owner contributions. In the current economic reality in which developers often conduct business in corporate form, and the real estate development is owned in LLCs, the IRS seems to be fighting a rearguard action against exclusion of non-owner contributions.
In this author’s opinion, the opportunity to carefully structure a transaction to pass muster under the statute as currently interpreted by the IRS, while very narrow, continues to exist. Inevitably, a transaction will be structured that is designed to meet all the conditions of the case law and that also involves a direct investment by a corporation. In that case, based on the foregoing analysis, the result should be non-inclusion in income for the corporation. It remains to be seen how the IRS will respond to such a case, but if and when such a case is litigated, it may change the tax landscape for non-owner contributions.