Federal Income Tax Consequences of State Economic Development Incentives After Passage of Tax Cuts and Jobs Act
Co-Authored by: Lindsay N. Richardson & Sam Johnson
South Carolina has a rich mix of economic development incentives. These include income tax credits, sales tax exemptions, property tax exemptions and credits as well as withholding tax credits. Incentives also include cash grants, e.g., Department of Commerce Set Aside Funds, and the occasional county grant. The state or county may also directly pay for or contribute land or public infrastructure to benefit an economic development project. South Carolina TIF statutes may result in substantial funds benefiting private real estate developers. Can the receipt of these incentives trigger federal income tax liability to the fortunate recipient?
On May 23, 2008, the Internal Revenue Service issued Coordinated Issue Paper LMSB-04-0404-023 (CIP) addressing its position as to the federal tax treatment of certain state and local tax incentives. The state and local tax incentives covered are referred to as “location incentives.” These types of incentives include abatements, credits, tax rate reductions and exemptions which are used by state and local governments to induce companies to relocate, expand or maintain facilities in a particular area.
As stated in IRS Tier I Issue: IRS Section 118 Abuse Directive #4, the IRS issued this CIP not to declare incentives as taxable income but rather to counteract a strategy used by some corporate taxpayers of claiming a current federal income tax deduction for the full state or local tax incentive amount as if that amount had actually been paid by the taxpayer as a state and local tax (e.g. deducting taxes on a fee-in-lieu as if there was a 10.5% assessment ratio rather than the 6% ratio contained in the fee). Under this strategy, the corporate taxpayer under the former law would recognize the incentive amount as gross income for federal purposes, but not as taxable income because, as discussed below, (under the former law) such amount would be treated as a contribution to the taxpayer’s capital. In essence, the corporate taxpayer would get the federal tax deduction without any corresponding taxable income.
The IRS concluded in its CIP that such state and local tax incentives generally (1) did not result in federal gross income to the recipient corporate taxpayer; (2) were not a contribution to the taxpayer’s capital; (3) did not reduce the taxpayer’s basis in its property; and (4) were not allowed as a deduction for taxes that are paid or accrued. Alas, the IRS’s interest in state tax incentives did not end there. On November 3, 2017, the IRS included "Economic Development Incentives" as part of its eleven Large Business & International ("LB&I") Compliance Campaigns to ensure compliance with section 118 of the prior law.
The IRS did prior to the current law consider receipt of some incentives as subject to federal income taxes, most recently in Ginsberg v. United States, F.Cl. (17-CV-00075)(2018) and Maines v. CIR, 144 T.C. No. 8 (Tax Court 2015); and the IRS considered receipt of some incentives by non-corporate entities as taxable income.
At the end of 2017, the U.S. Congress adopted H.R. 1, commonly referred to as the "Tax Cuts and Jobs Act," which has substantially changed the rules for corporations.
This article summarizes the general principals of incentives as subject to federal income taxes, under the new (and old) law and attempts to apply those principals to South Carolina’s incentives. The article discusses receipt of incentives by both corporations as well as LLCs and other entities. The article also discusses the exceptions to taxability which remain in place.
The granting of incentives by state and local government is now more in the public eye than in previous years. GASB 77, which requires the disclosure of certain incentives by state and local governments became effective on December 31, 2015 and will be included for the first time in State and Local Government Annual Reports for FY 2016-17. Many of these Reports will be posted online from November 2017 through early 2018. State and Local governments may report the granting of incentives under GASB 77 on either an aggregate or per-project basis, although the vast majority will report on an aggregate basis. Many Commerce Departments report State and Local Government grants and other incentives in an Annual Report, which is also typically posted online as well.
 Senate Democrats challenged the name "Tax Cuts and Jobs Act" under the Byrd Rule and the new official Title is "An Act to provide for the reconciliation pursuant to titles II and V of the concurrent resolutions on the budget for fiscal year 2018." Naturally, we will refer to it as the Tax Cuts and Jobs Act, or H.R. 1.
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