New Jersey: Discretionary incentives were not contributions to capital

The U.S. Court of Appeals for the Third Circuit recently reversed a decision by the U.S. Tax Court, and in doing so held that a company’s receipt of economic incentives from New Jersey were taxable. The state of New Jersey offers an economic incentive program called the Business Employment Incentive Program, which provides cash grants to companies willing to relocate or expand to New Jersey. A company that successfully obtains a grant under the Program is required to maintain a minimum number of employees and remain at the new location in New Jersey for a certain time period. However, no restrictions are placed on how a company can use the awarded grant money. The grant amounts are based on a percentage of state income taxes withheld from the wages of the company’s new employees in New Jersey.

In 2002, a taxpayer relocating from New York to New Jersey was approved for the Program. Over the next decade, the taxpayer received more than $170 million in cash grants from New Jersey. On the taxpayer’s federal tax returns, the grants were excluded from gross income as nontaxable, non-shareholder contributions to capital. The Commissioner of Internal Revenue issued a deficiency notice for tax years 2010 to 2013, and the taxpayer petitioned the Tax Court for review.

Under section 118 of the Internal Revenue Code, a corporate taxpayer’s gross income does not include any contributions to the capital of the taxpayer. A Treasury Regulation (26 C.F.R. section 1.118-1) interpreting section 118 (as it existed prior to the passage of the Tax Cuts and Jobs Act in 2017) provides, as an example of a contribution to capital, “the value of land or other property contributed to a corporation by a governmental unit or by a civic group for the purpose of inducing the corporation to locate its business in a particular community.” The Tax Court found that the taxpayer’s grants from New Jersey fell “squarely within the four corners” of the Regulation, and agreed that the grants should be excluded from the taxpayer’s gross income. The Commissioner subsequently appealed to the U.S. Court of Appeals.

On appeal, the Commissioner argued that even though economic incentives provided to businesses for relocation-inducement purposes may qualify as contributions to capital, they must meet two tests under U.S. Supreme Court precedent: (1) the payments must be restricted to use as capital, and may not be available for the payment of operational expenses, such as wages or dividends; and (2) the payments may not be direct compensation for services rendered by the business.

The appellate court reviewed previous Supreme Court cases analyzing the taxability of governmental contributions to corporations. For example, in a case in which a payment was made to a railroad company to reimburse costs for the construction of a railroad, the payments were determined to be nontaxable contributions to capital. In contrast, when payments were made to a railroad company to provide a minimum operating income, the payments were determined to be taxable income. Taken together, the appellate court concluded that unrestricted government payments, such as the incentives at issue, indicate an intent to provide a company with additional income rather than a contribution to capital.

The New Jersey cash grants provided to the taxpayer were without any restrictions on their use, and were calculated based on wages paid to employees, rather than the taxpayer’s costs to relocate. Therefore, the court agreed with the Commissioner that the grants were not contributions to the taxpayer’s capital, but rather supplemented the taxpayer’s income. Having determined that the cash grants did not satisfy the first test relied upon by the Commissioner, the court did not consider the second test, and reversed the decision of the Tax Court.

The Tax Cuts and Jobs Act modified IRC section 118 by creating an exception to the definition of a contribution to capital. Under a new subsection, the term “contribution to the capital of the taxpayer” does not include “any contribution by any governmental entity or civic group (other than a contribution made by a shareholder as such).” Therefore, beginning after enactment of the Act, certain government contributions to corporations must be included in gross income. With questions on Commissioner v. Brokertec Holdings, Inc. please contact Harley Duncan at 202-533-3254.