Federal Treatment of State and Local Tax Incentives
Why tax incentives do not result in an increase of wealth to the taxpayer.
June 26, 2008
by Mary Bernard, CPA/MST
Many states use various tax incentives to encourage the expansion of local business and to attract new businesses to the area. State and local tax incentives encourage taxpayers to expand their businesses, relocate facilities or create new jobs. These incentives can be in the form of tax credits, tax rate reductions, tax abatements and exemptions. Generally, these incentives are treated as a reduction of state and local tax expense for federal tax purposes.
However, some taxpayers chose to treat the tax incentives as income received, with a corresponding payment of taxes subsequently made by the taxpayer.
Under this scenario, the corporation reports the tax reduction amount as income under IRS code Section 61, but is excludable under Section 118 as a contribution to capital. Then the corporation claims a tax deduction for the full, unreduced tax liability under Section 164. The corporation subsequently reduces the basis of its property in the amount of the Section 118 exclusion according to Section 362(c). If money is received as a contribution to capital by a non-shareholder, the basis of property acquired with the money within the following 12-month period is reduced by the amount of the contribution. If this theory works, the corporation gets a current deduction for a tax it didn't pay with a downside of a possible income increase later.
The Coordinated Issue Paper (LMSB-04-0408-023, May 2008) concludes that a state tax incentive is not an item of gross income under Section 61, regardless of the form as a credit, abatement, exemption or rate reduction. The incentive should be treated as a reduction of state or local tax expense. This treatment does not depend on whether the tax is paid first and rebated or abated initially. The incentive is not deductible as a tax paid or accrued under Section 164 and cannot be treated as a contribution to capital that reduces basis in assets. The IRS position rests on the statement that the taxes are never due and payable.
The government reasoning is based on the conclusion that tax incentives do not result in an increase of wealth to the taxpayer, therefore it cannot result in income under Section 61. The incentive is applied against a current or future tax liability of the taxpayer, and should be treated as a reduction in state tax liability, for purposes of federal income tax. The taxpayer generally does not receive money that would result in income for federal income tax purposes. The incentive would also not qualify as a cancellation of debt, which could result in income, because the tax involved is never due and payable.
Consequently, if there is no income involved in this tax incentive, there can be no corresponding contribution to capital under Section 118. The basis reduction rule of Section 362 cannot be applied to this transaction. Tax incentives cannot be used to purchase property — only to reduce the state and local tax liability, which is a current operating expense, not a capital expenditure.
Even if the incentive could be considered an item of gross income under Section 61, it is unlikely that it would qualify as a contribution of capital. Under Section 118, the contribution must become a permanent part of working capital structure, be bargained for, not be compensation for services, be a benefit to the recipient commensurate with its value, and ordinarily used to produce additional income. A tax incentive would not generally fulfill these requirements.
Tax incentives are not deductible expenses under Section 164 as the taxpayer does not pay, and is not liable for, any taxes in excess of the amount remaining after all applicable incentives are applied. As with all expenses, the taxpayer can only deduct those expenses for which there exists a valid liability.
The IRS's decision regarding the treatment of tax incentives in this paper closely follows that of positions taken regarding the nontaxable nature of property tax rebates, frequent-flyer discounts and the recent Economic Stimulus payments.
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Mary F. Bernard, CPA/MST is a Tax Principal and Director of State and Local Tax Services at Kahn, Litwin, Renza & Co., Ltd. in Providence, RI.