IRS Releases Settlement Guidelines on Treatment of Corporate SALT Incentives

By: Jon R. Stefanik II

On March 2, 2011, the Internal Revenue Service released a heavily redacted Appeals Settlement Guidelines document (the “Guidelines”) addressing the federal tax treatment of a corporation’s receipt of state and local tax (“SALT”) incentives to induce it to expand, maintain or relocate its facilities.  The Guidelines are available here.

Under Section 118(a) of the Internal Revenue Code, the gross income of a corporation does not include non-shareholder capital contributions.  A threshold question in any case is whether a non-shareholder’s transfer of cash or other property to a corporation is in fact a capital contribution as opposed to another type of payment, such as compensation for services rendered (which clearly would be included in income). The U.S. Supreme Court has identified a number of factors to consider in determining whether a non-shareholder’s transfer of cash or benefits to a corporation constitutes a tax-free non-shareholder capital contribution.  See U.S. v. Chicago, Burlington & Quincy R.R. Co., 412 US 401 (1973).

The benefit of Section 118(a) exclusion comes at a cost. In the case of cash contributions, Section 362(c)(2) requires a corporation to reduce the basis of any property acquired with the contributed cash during the 12 months succeeding the contribution. For example, if a corporation receives a non-taxable, non-shareholder capital contribution of $100 on day 1, and on day 2 uses that $100 to acquire a parcel of real estate for $100, the corporation’s basis in the real estate would be zero.

In isolation, the interaction of Sections 118(a) and 362(c)(2) produce a reasonable result, ignoring timing differences.  So why are the IRS’ Guidelines necessary?  In the context of SALT incentives, some corporate taxpayers have claimed a federal income tax deduction under Section 164 for the full, un-credited amount of their local tax burden.  In a typical scenario, a corporate taxpayer would argue that it paid its state or local tax in full (thus entitling it to a full deduction), and that a portion of the tax paid was merely returned as a non-taxable, non-shareholder capital contribution.

The Guidelines analyze the factors set forth in Chicago, Burlington & Quincy and its progeny, as well as other authorities relevant to Sections 61(a) and 164, and asserts the IRS’ position as follows:

(i)         SALT incentives do not constitute income under Section 61(a);

(ii)        SALT incentives do not constitute Section 118(a) non-shareholder capital contributions;

(iii)       Because Section 118(a) does not apply, Section 362(c)(2) does not apply and a corporate taxpayer acquires basis in any property purchased with funds attributable to SALT incentives;

(iv)       A corporation is not entitled to a Section 164 deduction for that portion of its state or local tax liability that it does not actually pay.

The difference between the Service’s position and that asserted by many taxpayers is essentially a timing difference but, as demonstrated by the following example, that timing difference can be significant in the case of non-depreciable property.

Assume a corporate taxpayer has a SALT burden of $500 and receives a SALT credit of $100 to induce it to stay in its present location.  The corporation uses the $100 credit to purchase non-depreciable real estate for $100.  The consequences of each party’s position is set forth below:

Under the taxpayer’s position, there is no current income attributable to the SALT incentive, and a $500 current deduction against other ordinary income.  The property will have a zero basis, but the impact of that basis adjustment will not be realized until the corporation sells the property.  Under the IRS’ position, there is no current income attributable to the SALT incentive, and there is only a $400 current deduction against other income. The taxpayer acquires full cost basis in the property, but the impact thereof will not be realized until the taxpayer sells the property (and offsets any amount realized with the basis).

The difference in approaches essentially centers on the timing and nature of the tax benefit related to the SALT incentive.  The taxpayer will ultimately receive a tax benefit; the only issue is when that benefit will be realized (currently as a deduction under Section 164 or in later years, either in the form of cost recovery deductions or as an offset against amount realized).  The approach set forth in the Guidelines  is most beneficial to the IRS.

The actual “settlement guidelines” portion of the Guidelines is completely redacted, so it is not clear how the IRS is going to approach settlement of this issue.  What is clear, however, is that taxpayers taking the position described above and claiming a full, un-credited SALT deduction will be challenged.