Congress often uses the tax code to encourage certain actions and behaviors from businesses. But lately, the IRS seems to be working at cross purposes with those efforts.

Take, for example, the tax incentives that Congress provides to encourage public-private partnerships. “The tax code says that if the government provides funding to a corporation to perform a project that will benefit the public at large, those funds are tax- free,” says Dwight Mersereau, a partner in Crowell & Moring’s Tax Group. The idea behind that statute is that taxing such funding could either discourage private-sector participation or drive up the government’s costs. For example, if a project required $100 million and that is what the government offered, the contractor might be left with just $65 million after taxes to complete the effort—which would not be workable. Or the government would have to increase its funding to cover the tax and make the project viable, boosting the government’s bill to something like $154 million.

In a recent case, Congress directed the Federal Communications Commission to work with the private sector in a situation where this tax-benefit rule should apply. In its requests for proposals, the FCC specifically said it should apply. However, when a potential vendor took the question to the IRS, the agency said that it would consider the funding as taxable income for the vendor. The vendor declined to bid on the work.

Similarly, under the American Jobs Creation Act of 2004, Congress provided tax incentives for companies that locate their manufacturing in the U.S. However, the IRS has ruled that those benefits go to the company actually doing the work—which often means subcontractors. “The problem with this is the company that does the work may not be the one that decides where the product will be manufactured,” says Mersereau. “So the IRS is directing the incentive to the wrong party.” Thus, the primary company is likely to go with the lowest-bidding subcontractor—which could well be in another, lower-cost country.

“With these aggressive positions, the IRS is undermining what Congress intended,” he says.

DESPERATION AND LITIGATION

These kinds of disputes have traditionally been settled in IRS appeals hearings. However, the IRS has changed that process by having the traditional independent appeals officers joined by “issue specialists.” “Those specialists are basically deciding the issue, not the appeals officer,” says Mersereau. With that shift—and the IRS’s budget-driven staff cuts—“the appeals system has broken down on some of these issues,” he says.

The agency’s stand on congressionally mandated incentives is contentious enough that a number of companies have taken the IRS to court. On the manufacturing incentive issue alone, Mersereau says, “there already have been about a dozen cases in litigation, all on that one code section. That’s an indication of the aggressive position that the IRS is taking on these issues. Taxpayers don’t choose litigation lightly.”

Looking ahead, this Congress-IRS impasse is not likely to be resolved. That may limit the usefulness of these tax incentives, and reduce the attractiveness of public-private partnerships for contractors. If companies do decide to pursue such partnerships, they should not assume that an agency’s—or Congress’s—stated goals are a given. And, says Mersereau, “they should be thinking about the possibility of having to litigate their position and plan for that—keeping things privileged, being careful about how they marshal evidence in support of their position. They should go in with the mindset, right from the beginning, that this is going to be litigated.”