Did you know that awards of cash or property by governmental entities to businesses to incentivize their location in a state or locality, or to prevent their relocation out-of-state, are potentially excludable from federal taxable income? A non-taxable receipt of cash is definitely a win-win for incentive fund recipients.
Many states, including Texas, have set up economic development funds to be used to incentivize companies to select their state for the location of a facility. These funds are often referred to as "deal-closing funds" since they are sometimes combined with a local tax moratorium or other incentives in order to "seal the deal" as to site selection. When the awarded funds are not subject to tax, they are of even greater value to the recipient.
Contributions to the capital of a corporation by its shareholders are generally not taxable since they are not considered to constitute gross profit from the business operations of the corporation. This same rule may also apply when the contribution to capital is made by a non-shareholder, such as a governmental entity.
Internal Revenue Code Section 118 excludes from taxable income "contributions to capital of a corporation by non-shareholders." There have been a large number of litigated cases with respect to Section 118, including a number of United States Supreme Court cases. These cases have developed specific criteria for the exclusion. In general, however, the key question is whether the intent of the contributor was to make a capital contribution.
The difficult issue with many of the deal-closing funds arises from the presence of job creation targets in the award agreements. For example, Texas Enterprise Fund agreements usually follow a format that specifies the number of jobs to be created, a definition of a "job" for this purpose and a schedule for addition of such jobs. They also typically include a "clawback" provision that provides that, if the number of jobs created by the business falls short of the target, a portion of the award must be returned.
The IRS has asserted that job targets and clawbacks demonstrate a government intent to subsidize operating expenses, such as payroll, rather than to contribute to capital. Although the case law support for the IRS position is very thin, the IRS nevertheless persists in its position due to its policy of narrowly interpreting statutory exclusions from income. Depending upon the terms of the grant, however, a taxpayer may have sufficient support to take the position that the award is excludable.
A tax lawyer now with Gardere has obtained for a client a Private Letter Ruling (PLR) from the IRS that a large Texas Enterprise Fund award was excludable from the client's federal taxable income. As far as we are aware, this is the first favorable PLR with respect to a Texas Enterprise Fund award and the first with respect to an award containing job targets. Even though the ruling will be extremely helpful to the recipient taxpayer, it may not be relied upon by other taxpayers to ensure that they obtain the same result. A taxpayer must obtain its own PLR in order to be confident that the IRS will not attack the exclusion.
It should also be noted that, even when the exclusion is available, it may not be a permanent exclusion. The IRS exacts its pound of flesh for the exclusion by denying a cost basis for the capital assets purchased with the funds. This means that the taxpayer will not be able to depreciate assets acquired with the funds and will have greater gain if and when there is a subsequent disposition of the assets, thereby possibly converting the tax benefit into long-term deferral rather than permanent exclusion. Of course, long-term deferral can itself be very beneficial in certain circumstances.