Press Room: Tax Release
Planning for State and Local Incentives Post Tax Reform
Prior to enactment of the Tax Cuts and Jobs Act (TCJA), Sec. 118 of the Internal Revenue Code exempted most non-shareholder contributions to capital that were made to a corporation from taxable income. Historically, Sec. 118 was the principal authority that corporations used to exclude state and local incentives from federal taxable income whenever local governments provided financial assistance or property to a corporation for facility expansions and/or business relocations. The general rule of exclusion was only hemmed in by language in the statute that removed contributions in aid of construction or any other contribution as a customer or potential customer from the definition of exempt non-shareholder contributions to capital (except for certain regulated public utilities).
The TCJA amended Sec. 118 by reducing the scope of non-shareholder contributions that are exempt from federal taxable income. Specifically, new Sec. 118 provides that non-shareholder contributions to capital made by any government entity or civic group are included in the federal taxable income of the corporation. The change repealed what Congress had come to believe was a federal subsidy for local incentives. If localities wanted to enrich corporations in order to lure jobs and infrastructure to their jurisdiction, the federal government shouldn’t be deprived of the right to tax the income received by the corporation.
New Sec. 118 applies to all contributions made after the enactment date of the TCJA (December 22, 2017). Contributions associated with master development plans negotiated before the effective date of the TCJA are grandfathered under the old rules (i.e., remain tax exempt). The change promises an immediate and dramatic impact on the planning for state and local incentives in 2018 and beyond.
The Mechanics of Non-Shareholder Contributions to Capital
Although Sec. 118 describes an exemption of non-shareholder contributions from federal taxable income, the benefit it confers is really a deferral of federal taxable income. Section 362 requires corporations to take a basis of zero in any exempt contribution or in any property acquired within 12 months of receiving an exempt cash contribution. If a corporation receives cash in excess of the value of any property it purchases with the contribution, Sec. 362 further requires that the corporation reduce its basis in other assets to account for the full value of the contribution. As a practical matter, an exempt non-shareholder contribution to capital typically results in lower depreciation deductions and/or a greater measure of taxable gain on the eventual sale or disposition of the assets connected with the contribution. From a cash- flow perspective, old Sec. 118 allowed non-shareholder cash contributions from local governments to provide working capital to a corporation to invest in the facilities or infrastructure that was desired by the municipality. Under new Sec. 118, there will be no deferral of tax; 21% of the assets contributed to a corporation will be used to pay federal income tax when the contribution is made (at the new corporate tax rate).
Importantly, an abatement of local tax is not considered a contribution to capital under the TCJA. The Committee Conference Report that accompanied the TCJA specifically noted that a contribution of land to a corporation by a municipality that is not made in exchange for stock of equivalent value is includable in the corporation’s gross income. However, a municipal tax abatement for locating a business in a particular jurisdiction is not a contribution to capital (and is not includable in gross income). The conclusion drawn from the new legislation is that state and local governments will demonstrate a strong preference for tax abatements instead of contributions of land, property or cash to target corporations. The abatement of local taxes over some period of time in lieu of a cash contribution has obvious implications on cash-flow for corporate development projects.
Maximizing the Value of State and Local Incentives Under New Section 118
The change to Sec. 118 does not mean that state and local incentives will disappear in 2018 and beyond, but it does mean the incentives will change. Taxpayers will have to be creative in negotiations to preserve the benefits of local incentives without incurring new federal tax liabilities. A few simple strategies can be employed to maximize the value of local incentives.
- Embrace tax abatements - Future tax abatements have to be discounted to reflect the net present value of the cash or property incentives they are intended to replace, but local governments may be more generous with future abatements to avoid paying 21% of their incentive awards to the federal government.
- Negotiate the use of government-owned facilities - Section 118 only applies to property or cash that is contributed to a corporation. If a city or town builds and owns a parking facility, roadway or other public asset primarily for use by a corporation, the business can benefit from the investment in infrastructure without accepting a taxable contribution to capital.
- Revisit existing incentive agreements - Any corporation with a partially completed incentive plan as of December 22, 2017, should revisit the terms of the agreement to maximize the contributions that can be made under the grandfathered plan. To the extent that future contributions are not grandfathered, the corporation may want to explore tax abatements instead of accepting taxable contributions.
The New Paradigm for State and Local Incentives
State and local incentives have long played an important role in the decision-making process for corporations with plans to expand or relocate facilities or headcount. The amendments to Sec. 118 and the inclusion in taxable income of cash or property contributed by local jurisdictions will certainly change the way corporations evaluate local incentives, but the change doesn’t mean local incentives are less valuable. With proper financial forecasting and a sound strategy for negotiating tax abatements, local incentives will continue to play an important role in corporate planning. The use of government-owned infrastructures and maximizing contributions under grandfathered master development plans demonstrates that creative solutions can be found to the challenges created by the new Sec. 118.