• IRS Issues Guidance on Taxability of Government Grants
  • November 19, 2010 | Authors: Jody J. Brewster; Sean M. Shimamoto
  • Law Firm: Skadden, Arps, Slate, Meagher & Flom LLP - Washington Office
  • On November 12, 2010, the Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) released Revenue Procedure 2010-45 and Revenue Procedure 2010-46, providing guidance to taxpayers regarding the federal income tax treatment of grants made by the United States government.

    Section 118(a) of the Internal Revenue Code1 provides that a corporation's gross income does not include certain non-shareholder contributions to the capital of that taxpayer. However, in the case of such a non-shareholder contribution to capital, Section 362(c)(2) requires a basis reduction in the corporation's property. The revenue procedures provide that the IRS will not challenge a corporation's treatment of specific federal grants as a non-shareholder contribution to the capital of the corporation under Section 118(a), provided that the corporation properly reduces the basis of its property under Section 362(c)(2) and the regulations thereunder.

    To date, Treasury and the IRS have issued a total of four revenue procedures providing similar "safe harbor" treatment under Section 118(a) for certain federal grants:

    • Rev. Proc. 2010-46 (Department of Transportation grants under the High-Speed Intercity Passenger Rail Program and for capital investments in surface transportation infrastructure)

    • Rev. Proc. 2010-45 (Department of Energy grants under the Electric Drive Vehicle Battery and Component Manufacturing Initiative)

    • Rev. Proc. 2010-34 (broadband grants from the Department of Agriculture and the Department of Commerce)

    • Rev. Proc. 2010-20 (DOE Smart Grid Investment Grants).

    Treasury and the IRS appear to have adopted the approach of addressing specific federal grant programs on a particularized basis, rather than issuing broad-based guidance. Although the four revenue procedures provide welcome guidance for those taxpayers whose grants are covered by the safe harbor, federal and state governments have provided many grants that are not so covered.

    A corporate taxpayer who receives a grant that is not specifically described in one of the revenue procedures listed above may look to the general Section 118(a) rules to determine whether the grant constitutes a non-shareholder contribution to capital that may be excluded from income. In addition to scrutinizing the intent of the transferor in making the payment, the IRS uses a five-factor test, set forth in United States v. Chicago, Burlington & Quincy Railroad, 412 U.S. 401 (1973), to determine whether a payment constitutes a Section 118(a) non-shareholder contribution to capital:

    • The contribution must become a permanent part of the transferee's working capital structure;

    • The contribution must not be compensation for specific, quantifiable services, e.g., a direct payment for services provided by the transferee to the transferor;

    • The contribution must be bargained for;

    • The contribution must foreseeably benefit the transferee in an amount commensurate with its value; and

    • The contribution must ordinarily be employed to generate additional income.

    Taxpayers desiring certainty regarding the Section 118(a) treatment of a grant may consider seeking an IRS private letter ruling.

    In addition, Section 118 applies only to corporations and the revenue procedures are expressly limited to corporate taxpayers. With respect to non-corporate taxpayers, the IRS has taken the position that neither Section 118 nor any common law doctrine relating to contribution to capital applies to partnerships (including LLCs treated as partnerships for federal income tax purposes) to permit the exclusion from gross income of amounts paid to a partnership by a non-owner. See IRS Coordinated Issue Paper, Non-Corporate Entities and Contributions to Capital (Nov. 18, 2008).

    Thus, while the revenue procedures provide welcome relief to the subset of corporate taxpayers whose grants fall within the ambit of the procedures, they provide little comfort to corporate taxpayers receiving other types of grants and to non-corporate taxpayers receiving any kind of grant (whether described in the revenue procedures or not). As noted above, corporate taxpayers may consider whether they can meet the five-factor test under Section 118(a). Non-corporate taxpayers seeking to exclude a grant from income will have to consider alternative arguments or other approaches. Non-corporate taxpayers also may consider testing the IRS position that common law doctrines are not available to exclude from income contributions to capital by non-owners, as it is not clear, from a policy perspective, why exclusion treatment should be limited to corporations.



    1 Unless otherwise indicated, all "section" references are to the Internal Revenue Code of 1986, as amended.