Tax Reform’s Changes to the Treatment of Non-Shareholder Contributions to Capital
The 2017 tax reform act amended Section 118 of the Internal Revenue Code, to dramatically reduce the ability of a corporation to exclude from its gross income grants that the corporation receives from federal, state, or local governments or from civic groups to incentivize corporate investments. Many energy infrastructure projects benefit from exactly these kinds of incentives. Now and in the future, project developers need to be aware of and understand these changes, so that they can work to minimize the adverse consequences of the tax reform act’s amendment.
Before Tax Reform. Before the passage of the tax reform act, Section 118 provided that a corporation’s gross income did not include any contribution to the capital of the corporation. The regulations that accompanied this section explained that this exclusion applied to contributions received from persons other than shareholders (i.e., so-called “non-shareholder contributions to capital”). Thus, for example, if the government or a civic group contributed property to a corporation in order to persuade the corporation to locate its business in a specific place or to enable a corporate expansion, the corporation took a basis of $0 in the land received. In this way, Section 118 enabled a tax deferral on the non-shareholder contribution to capital.
What Tax Reform Changed. In the first iteration of the amendments to Section 118, the House of Representatives proposed repealing the section in its entirety and replacing it with a new section that would have defined gross income to include all contributions of capital to any entity, other than contributions of capital to a corporation that are made in exchange for shares in the corporation equal to the value of the property contributed. Ultimately, this proposal was abandoned because of concerns about its unintended consequences.
The final tax reform act thus retained Section 118, but with certain amendments. The amended Section 118 provides that no contribution made by a governmental entity or by a civic group may be excluded from the recipient’s income as a non-shareholder contribution to capital, as had been possible before the tax reform act.
The conference report on the tax reform act clarified a few points:
- Section 118 only applies to corporations; and
- Tax abatements are not considered contributions to capital and thus are not subject to Section 118 (in contrast, a grant of land by a municipality would be treated as a contribution to capital).
At the same time, these amendments have led to new ambiguities:
- Because the amendment excludes any governmental contribution, it excludes, on its face, contributions from the federal government. Thus, a percentage of any federal governmental contribution will be returned to the federal government in taxes.
- The amendments do not define “civic group,” even while sweeping broadly to cover nearly all payments from civic groups.
- The amendment applies to contributions made after December 22, 2017, the day that the tax reform act was signed into law. However, the changes do not apply to contributions made after that date by a governmental entity that are made pursuant to a “master development plan” that had been approved prior to December 22, 2017. The amendments do not define “master development plan,” however.
Looking ahead. The full implications of the Section 118 amendments are unlikely to be fully understood for some time, however, there are planning opportunities that corporations, governments, civic groups, and practioners can take advantage of:
- Structuring: Consider structuring transactions between corporations and civic groups or government entities so as to minimize the receipt of taxable non-shareholder contributions to capital. For example, instead of a cash grant, a municipality can give a corporation a tax abatement, which is not treated as a contribution to capital.
- Contribution Size: In determining the amount of a contribution to a corporation, if the contribution cannot be structured so as not to be treated as a contribution to capital, the taxes that the recipient will be required to pay on the contribution should be taken into account in determining the size of the contribution. This is particularly true for contributions from the federal government, in which the federal government will be making a grant to a corporation, a percentage of which will be paid right back to the federal government in taxes.
- Rethinking Existing Grant Arrangements: Corporations that have already entered into grant agreements that include substantial future payments should consider the uncertainty surrounding future payments under those grants. Such corporations may wish to seek clarification from the IRS regarding how these particular payments will be treated.
The full implications of the tax reform act’s restrictions on the ability of corporations to exclude from gross income grants that they receive from federal, state, or local governments or from civic groups to incentivize corporate investments will play out in the coming months and years. However, there are important planning opportunities that taxpayers can take advantage of today to mitigate future surprises and to ensure that these transactions are structured to achieve their intended and desired benefits.