Taxability of State and Local Tax Incentives: Pre Vs. Post "Act"

Josh Cook (Jul, 2018)

Is your company eligible for a state or local tax grant in the near future? There are several items that you need to be aware of when you consider applying for a grant. The Tax Cuts and Job Act (the Act) signed by President Trump enacted the largest restructuring of the federal tax code since the Tax Reform Act of 1986. This article will look at the significant changes to the treatment of certain tax incentives offered to taxpayers by state and local governments.

Typically, state and local governments will offer cash grants to be used towards expansion projects or equipment purchases (with some grants reimbursing previously incurred costs) within an organization that will incentivize growth within their community. In order to qualify for the grant and receive the funds, businesses are usually required to reach certain employment or income benchmarks within the next few years to receive the maximum amount of funds. The major question is whether or not the funds received by the recipient are taxable?

Often, when an organization receives monies from an outside source those monies would be taxable, right? Not necessarily. Before the Act was signed into law, this would be a complicated question. The Internal Revenue Code (IRC) § 61(a) broadly defines gross income as all income from whatever source derived. In reading this section of the code alone, a business owner could possibly jump to the conclusion that their state incentives were taxable. However, the former IRC § 118 excluded capital contributions from gross income. This exclusion previously extended beyond the shareholder, to include contributions made by a governmental unit for the purpose of inducing the corporation to locate its business within a particular community, or expand operations in its current location.

Under the Act, IRC § 118 has been amended to expressly provide that the term "contribution of capital" does not include any capital contributions by any governmental unit or an individual other than a shareholder. As a result, contributions of money or property to an organization by a governmental unit will qualify as gross income and will be picked up as taxable income unless certain exclusions apply (i.e. exclusion of government transfers, general welfare exclusion, lack of dominion and control). The amendments to IRC § 118 apply only to contributions made after December 22, 2017.

There will be circumstances where governmental grants have been approved, but funds were not issued before the Act was in effect. If your grant was approved by a government entity before the enactment date, but the funds were not distributed until after December 22, 2017, there is a grandfather clause in the Act. This allows a taxpayer to exclude these funds from their gross income in the period that the funds are received.

While the following code section does not allow you to exclude monies from gross income under the Act, IRC § 362 (c)(2)(B) allows you to defer the income to a later tax period. This code section allows taxpayers who acquire assets with grant money to reduce their basis in the newly acquired assets by the amount of the grant money received, instead of including it in gross income. The grant money will not be picked up as income in the year of receipt, thus reducing taxable income in that period. By reducing the capitalized fixed asset cost, lower depreciation expense will be incurred in the current and following years, thus deferring income over those years. When the fixed assets are disposed in the future, there is a higher likelihood the taxpayer will incur a gain if sold because the original basis of the assets was reduced.

While the taxability of grants and incentive programs has drastically changed as a result of the Act, state and local tax credits will continue to have no impact on a taxpayer's federal income (Qualified Empire Zone Enterprise Real Property Tax Credit refunds are included in Federal income in the year received). This could be an opportunity for state and local governments to offer additional tax credits to incentivize growth moving forward, rather than by issuing grants. State and local governments could also respond to the amendment of IRC § 118 by offering incentives that are structured so that they would not be excluded as a contribution to capital.

It is not an easy task staying on top of the ever-changing tax code. It is very important to have a trusted tax professional help in navigating the path ahead.  Please contact your Dermody, Burke & Brown advisor if you have any questions related to the taxability of your state incentives, or to discuss any new incentive programs available to you.

 

The information reflected in this article was current at the time of publication.  This information will not be modified or updated for any subsequent tax law changes, if any.

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