Tax Reform and Economic Development Incentives and Grants

October 2019

Overview

Tax reform legislation changed the taxability of economic development incentives and grants for businesses and developers. Alaska Native Corporations will benefit from understanding these changes, and how they are affected.
 
Under Internal Revenue Code Section 118, corporate taxpayers were allowed, in most cases, to exclude contributions that came from non-shareholders, such as governmental branches and agencies, from taxable income. Under the new law, property contributed to a corporation by a governmental unit or by a civic group for inducing the corporation to locate its business in a particular community or to enable the corporation to expand its operating facilities, and other incentive payments, are now generally taxable to the corporation.
 
Unless the government contributes as a direct shareholder (i.e., takes back stock for its investment) in the corporation, the corporation receiving the upfront cash incentive can no longer exclude these contributions. It’s important to note that having a governmental agency receive stock is not very common and is not very desirable from the viewpoint of pre-existing shareholders due to the dilutive nature of the issuance.
 

Tax Basis of Property

Prior to tax reform, if property was acquired by a corporation as a contribution to capital and was not contributed by a shareholder as such, the adjusted tax basis of the property was zero. Therefore, no tax depreciation was allowed. This is essentially a deferral (through the basis reduction) for property “acquired by a corporation as a contribution to capital” or to property acquired with money “received by a corporation as a contribution to capital.”
 
After tax reform, tax basis in property equals the cost to construct or purchase the property for which the grant proceeds were used. Property is then eligible for tax depreciation once placed in service.
If a taxpayer is adversely affected by the statutory changes to Section 118, property and money are not treated as “a contribution to the capital of the taxpayer.” As a result, property received in this manner should have a fair market value basis if received in kind, and a cost basis if acquired with the proceeds of the grant.
 

Deferral Versus Elimination

As seen in the required basis adjustments, when deferral was allowed, the mechanism was more of a deferral technique, as opposed to a pure tax exclusion that eliminated income altogether. It resulted in a reduced tax basis in property, in exchange for avoiding income recognition, thus ultimately deferring the tax liability on the grant to a later time when the asset would have been depreciated or when the asset whose tax basis was reduced is sold. This deferral provision better enabled taxpayers to manage tax liability from receipt of the funds with related expenses once the funds were deployed.
 

Exceptions to New Rules

While this change is likely concerning for many Alaska Native Corporations that work in economic development trades and businesses, relief exists in the following two situations:
 
  1. When a taxpayer had a Tax Increment Financing plan or a master development plan in place prior to the passage of the law (Dec. 22, 2017). While the new law’s modification is effective for contributions received after Dec. 22, 2017, it does not apply to post-modification contributions if the contribution occurs pursuant to a “master development plan” approved by a governmental entity prior to the effective date.
  2. When a taxpayer located in a state that has opted out of the Section 118 modifications. For example, a taxpayer located in Connecticut, Georgia, Indiana, South Carolina or Tennessee may escape state taxation even though the incentive funds received by a corporation would now be subject to federal tax.
 

BDO Insight

There are tax-planning techniques around Section 118 to possibly avoid some of the immediate adverse income tax consequences:
  • Consider the use of partnerships as investment vehicles where the governmental entity is considered a partner as opposed to a shareholder, since Section 118 applies to capital contributions into corporations. (Note: the partnership transaction would need to be structured in a manner that does not result in an immediate accession to wealth or income to the non-contributing partner(s) through careful tax planning.)  
  • Consider negotiating with the governmental authority to provide tax abatements or tax credits, as opposed to making capital contributions of cash or property, as those forms of assistance are no longer treated as a tax-free contribution to capital.
  • Negotiate for the provision of periodic payments, as needed, to avoid immediate upfront income recognition and to defer the income recognition with the timing of related expenditure, to possibly create offsetting income tax deductions as those government funds are employed in the relevant project.
  • Direct the municipal investment toward a publicly owned infrastructure project, rather than providing cash grants to private businesses to take ownership of those assets underlying the respective government grants.
  • The term “master development plan” comes from the Conference Committee Report but there is no authority from Treasury or the Service that clarifies what it means from a definitional standpoint. Without such guidance, taxpayers may have a difficult time relying upon that exception.
 

Contact BDO for assistance with your tax planning, partnership structuring, and investments surrounding these changes.

Kevin Van Nortwick
Anchorage Tax Office Managing Partner
Chad Estes
Anchorage Tax Partner
   
Zac Rankin
Tax Managing Director