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Jamie C. Yesnowitz
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The recently enacted federal tax reform legislation contains an amendment to Internal Revenue Code (IRC) Sec. 118 that expands gross income for federal income tax purposes to include many previously untaxed state and local tax (SALT) incentives.1
Accordingly, taxpayers that receive significant funding and support from governmental entities, such as cash grants, no-cost land or equipment should consider the potential impact of this amendment on their businesses.
Historical Treatment of IRC Sec. 118
In general, the IRC broadly defines gross income as all income from whatever source derived.2
However, the U.S. Supreme Court has held that gross income does not include a contribution to capital, which led to the codification of such rule in IRC Sec. 118(a). Four U.S. Supreme Court cases3
(and numerous other cases, rulings and other guidance) have addressed the scope and nature of what constitutes a “contribution to capital.”
Further, prior to the enactment of the tax reform legislation, a federal regulation provided additional guidance regarding the “contribution to capital” exclusion.4
Specifically, the exclusion extended to “contributions to capital made by persons other than shareholders.”5
The regulation explained 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.”6
Beyond the conveyance of land, these contributions may include cash grants, buildings, and equipment and potential special purpose financing programs (including, for example, tax increment financing funds).
Impact of Tax Reform
The amended federal tax law retains the general rule that, in the case of a corporation, gross income does not include any contribution to its capital.7
However, the tax reform legislation amends IRC Sec. 118 to provide that “any contribution by any governmental entity or civic group (other than a contribution made by a shareholder as such)” to a corporation is no longer excluded from its gross income.8
The amendment generally applies to contributions made after December 22, 2017, but does not apply to contributions that were made pursuant to a master development plan that was approved prior to this date.9
The immediate result of this amendment is the above-mentioned types of contributions made by governmental units or civic groups to a business now become taxable, which may reduce the benefit of a given incentive to the business.
Due to the tax reform legislation, as well as other federal initiatives such as the Large Business and International Compliance Campaigns,10
the IRS is likely to scrutinize any previous exclusions under former IRC Sec. 118 to ensure conformity to the contribution of capital requirements. As a result, taxpayers may notice an increase in activity from the IRS in this area.
It should be noted that taxpayers may decide to challenge the new statute on the basis that the new legislation violates constitutional principles. In Edwards v. Cuba Railroad Co.,11
for example, Court held that contributions to capital are not income under the Sixteenth Amendment of the U.S. Constitution. Further, any attempt by Congress to redefine the phrase “contribution to capital” may exceed its authority – inasmuch as four U.S. Supreme Court cases have already specifically addressed what constitutes a “contribution to capital.”
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