Reduction in Basis Due to Government Grant

Technical topics regarding tax preparation.
#1
Chay  
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An S corporation with renovations already underway receives $40,000 in state/local government grant money paid in three equal installments to help with part of the renovations.

PLR 1003005 suggests that these payments should be considered non-shareholder contributions of capital under 362(c)(2). 362(c)(2) provides that "the basis of any property acquired with such money during the 12-month period beginning on the day the contribution is received shall be reduced by the amount of such contribution".

There are two complications to this issue.

Complication 1: The government authority has issued a 1099-MISC to the corporation with $40,000 listed as "other income" in box 3. The instructions to Form 1099-MISC indicate that it need not be issued to a corporation, so the fact it was issued implies that the authority may not have known about their corporate status. Does the 1099-MISC tell the IRS that the $40,000 was income and not a reduction in basis, as I assume it would be to an individual, or does it merely indicate that cash was transferred? Should the 1099-MISC be considered to contain an error? Is it worth bothering over?

Complication 2: The net cash payments are over $40,000 but they aren't lined up nicely with the grant monies the way that 362(c)(2) seems to want them to be. The transactions proceed as indicated below. All of the contractor payments listed below except for the final three payments are for related improvements to the property. Can these improvements be considered "acquired" on 6/8 when the final payment is made, and therefore fully covered by the grant money? Or can the grant money be applied to the improvements through some other logic even though a plain reading of the statute would suggest otherwise?

3/01 Contractor .....................(7,000.00)
3/08 Grant............................ 13,334.00
3/08 Contractor ....................(13,334.00)
3/15 Landlord reimbursement.. 50,052.44
3/15 Contractor.....................(50,052.44)
5/07 Contractor ....................(13,333.00)
5/10 Grant............................ 13,333.00
6/05 Grant............................ 13,333.00
6/08 Contractor.....................(11,260.00)
7/15 Contractor......................( 1,300.00)
7/15 Contractor.........................( 750.00)
8/05 Contractor.........................( 122.00)

Also, Freedom Newspapers, Inc. v. Commissioner is possibly relevant here so I figured I'd link to it.
Last edited by Chay on 9-Jul-2018 6:58pm, edited 1 time in total.
 

#2
Nilodop  
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I know of no situation where a 1099 would indicate simply that cash was transferred. It means the payer thought they were paying income, or at least that they thought they had to issue a 1099. So they made two mistakes - one that it is not income, and another that the recipient is a corporation. But I guess they haven't violated any law by issuing it. I'd try to get it "corrected", i.e., eliminated, but I would not spend much time doing so.

Is the plain reading of the statute to which you refer and that would suggest otherwise this language:
... the basis of any property acquired with such money during the 12-month period beginning on the day the contribution is received shall be reduced by the amount of such contribution.
? I have not seen that issue (i.e., the issue of the receipt of the capital contribution occurring before the payment for the item it was for) raised. I did not look at cases where the facts may have been similar, but if there are any, the issue was not raised.

Yes, I think there is other logic that can be applied. I'd bet that the written agreement under which the money was contributed by the state/local gov't. provides for a refund of any money that was not in fact expended for the intended purpose, and maybe even for penalties in that event. So my logic is simple - the capital comtribution was not "received" until the S corp. met its obligation to pay the contractor. Until then, it was. a payable to the state/local gov't.

I think your client wins the issue hands down.
 

#3
Chay  
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Nilodop wrote:I know of no situation where a 1099 would indicate simply that cash was transferred. It means the payer thought they were paying income, or at least that they thought they had to issue a 1099.

There is at least one case where a 1099 must be issued even though the payor knows the payment isn't income: a 1099-R with code "W" for long-term care insurance premium riders on a life insurance contract, which the IRS states should be disregarded by the taxpayer entirely. I suppose it's unlikely a non-shareholder capital contribution would get this kind of treatment but I'm at a point where I realize all bets are off with tax forms and anything might go when there's a situation I've never encountered before. I find state tax returns particularly vexing in their inconsistency.
Nilodop wrote:Is the plain reading of the statute to which you refer and that would suggest otherwise this language:
... the basis of any property acquired with such money during the 12-month period beginning on the day the contribution is received shall be reduced by the amount of such contribution.
?
[...]
Yes, I think there is other logic that can be applied. I'd bet that the written agreement under which the money was contributed by the state/local gov't. provides for a refund of any money that was not in fact expended for the intended purpose, and maybe even for penalties in that event. So my logic is simple - the capital comtribution was not "received" until the S corp. met its obligation to pay the contractor. Until then, it was. a payable to the state/local gov't.

Yes, that's the plain reading I'm referring to. Specifically there is the 5/7 payment occurring before the 5/10 grant - the statute would seem to prohibit the corporation from looking back three days and considering that payment to arise from the funds that they were going to receive on 5/10.

Your application of constructive receipt here is clever and something I hadn't thought of, but the goal isn't to delay constructive receipt of funds until a qualifying payment has been made. Rather, the qualifying payment has already been made, and the goal is to count "property acquired" (building improvements) by way of that payment as acquired using the grant funds yet to be received. If anything it would be helpful to delay constructive receipt of the property.
 

#4
Nilodop  
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I did not apply the doctrine of constructive receipt. The cash was actually received. I argued that it was not theirs until the payment was made a few days later. There is no specific authority, just an interpretation of the facts based on what I assume is in the contract.

Imagine if the entire grant had been paid before any payment was made to the contractor. Maybe just one day before.

But if your point is in the other direction - i.e., that the basis does not have to be reduced because the contribution was received after the payment was made to the contractor, then I disagree. You'd be arguing that 118 excludes the contribution, yet 362 does not require a basis reduction. You'd be hard pressed not to include the contribution in gross income.

Now what I'd like to see is a set of facts wherein the contribution is received more than 12 months before the property is constructed. I'd still see the same argument - it was not "received" as a contribution for the same reason - it was required to be refunded if the property was not bought/built in a certain time frame.

And how about this language in 118:
... the term “contribution to the capital of the taxpayer” does not include—
(1) any contribution in aid of construction or any other contribution as a customer or potential customer, and
(2) any contribution by any governmental entity or civic group (other than a contribution made by a shareholder as such).
?
 

#5
Coddington  
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The TCJA changed the statutory language as of 12/22/17. (I might be wrong on the exact effective date.) The dates in the OP are important for that reason.
-Brian

Director of Tax Accounting Methods & Credits
SourceAdvisors.com

Opinions my own.
 

#6
Chay  
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Nilodop wrote:[...]
But if your point is in the other direction - i.e., that the basis does not have to be reduced because the contribution was received after the payment was made to the contractor, then I disagree. You'd be arguing that 118 excludes the contribution, yet 362 does not require a basis reduction. You'd be hard pressed not to include the contribution in gross income.

I agree that the corporation is going to have to reduce its basis in something. "Complication 2", as I put it, is concerned with what property, specifically, receives a reduction in basis.

Regs. § 1.362-2(a) provides that "[p]roperty deemed to be acquired with contributed money shall be that property, if any, the acquisition of which was the purpose motivating the contribution".

Regs. § 1.362-2(b)(1) provides that any contribution in excess of the cost of the property deemed acquired is first applied to "[a]ll property of a character subject to an allowance for depreciation".

The corporation has enough depreciable property to absorb any excess contribution under Regs. § 1.362-2(b)(1). So, the only uncertainty here is what portion of the $40,000 should be applied to the "deemed acquired" property and what portion should be applied to all depreciable property.

The improvements related to the purpose of the grant, so far as I know, were complete on or around 6/8 when the final large payment was made to the contractor, and in total they did cost in excess of $40,000.00. The simplest and most beneficial position to take on this return would be that for the purposes of Section 362, the improvements are a single unit of property that wasn't "acquired" either until that final payment was made or the final work was done (either one would work).

If this position is not viable then the corporation must reduce the basis of unrelated property.
 

#7
Nilodop  
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Shucks, that makes it so much less interesting. I was hoping we could argue about an income exclusion with no basis reduction at all.

And now we know there is new language in 118.

There's a case that I saw while thinking about your facts that argues along the lines that 118 and 362 are not timing differences. I'll find it again later and post it.
 

#8
Chay  
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Nilodop wrote:I was hoping we could argue about an income exclusion with no basis reduction at all.

Supposing the corporation still had excess contributions after reducing the basis in all of its property to zero, I would in fact argue that no income need be recognized in that case. The reason is that 1) neither the statute nor the regulation concerned makes any mention otherwise and 2) this situation only matters in the case where the corporation is not liable to return the additional unused capital to the non-shareholder, and in that situation the excess capital contribution is in the nature of a gift.
 

#9
Nilodop  
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And IRS would argue that "the statute" does cover, right there in section 61. And that the transaction fails to meet the definition of a gift.
 

#10
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There are two complications to this issue.

Isn’t another (potential) complication the new tax law…the revision to Sec 118?
 

#11
Nilodop  
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Here's the case I mentioned in #7. https://www.leagle.com/decision/1992289 ... m283212661.

Petitioners argue that section 481 does not apply in this case because the issue with respect to the fees is a question of whether or not the fees are taxable, not a timing question as to when the fees should be considered income. In contrast, respondent argues that a recharacterization of the fees from contributions to capital to customer connection fees is a change in accounting method because a timing question for recognizing income or claiming deductions is also involved. Specifically, respondent argues that Saline Sewer, in addition to failing to report the fees in issue as taxable income, also incorrectly
reported the fees as a credit or reduction to the depreciable basis of assets, which effectively reduced Saline Sewer's depreciation expense over the life of the underlying assets. Accordingly, respondent argues that Saline Sewer's taxable income was increased dollar-for-dollar by moneys at issue over a period of several years.


With respect to the period from February 1, 1976 through 1983, respondent's depreciation argument is a red herring. During this period, the treatment of fees as either taxable customer connection fees or nontaxable contributions in aid of construction has no connection with depreciation. Section 118(b)(4) prohibits depreciation and requires a zero basis for assets built with contributions in aid of construction. Likewise, customer connection fees are taxed as current income, which also has nothing to do with depreciation. Therefore, no timing issue exists with respect to the fees, and section 481 is not applicable as a matter of law. Accordingly, we shall grant petitioners' second motion for partial summary judgment.


Coddington? Anyone?
 

#12
Chay  
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Nilodop wrote:And IRS would argue that "the statute" does cover, right there in section 61. And that the transaction fails to meet the definition of a gift.


§ 118 and the definition of a "contribution to the capital of the taxpayer" is the point of contention, not § 61. If the funds meet that definition, then § 61 specifically does not apply.

Regs. § 1.118-1 provides that non-shareholder contributions to capital generally fall within this definition, but that "the exclusion does not apply to any money or property transferred to the corporation in consideration for goods or services rendered, or to subsidies paid for the purpose of inducing the taxpayer to limit production".

§ 362(c) deals exclusively with non-shareholder contributions to capital. So, if we stipulate that § 362(c) applies to a situation, then the situation must by definition meet the requirements of § 118 and the regulations thereunder. Thus, neither goods nor services can be expected in return for the contribution. If we further stipulate that the corporation gets to keep the unspent cash no matter what they do with it, then the contributor has no expectation of any definite value in or purpose for the money, which implies a detached and disinterested generosity.

I could make the case for non-recognition based on the language of the statutes and regulations alone and the fact that no matter what happens under § 362(c), § 118 still applies. However, in showing how gift treatment also applies I have gone further and explained some of the logic behind those rules - specifically, why they don't mention any recognition of income and why they specify that goods and services cannot have been transferred.

Nilodop wrote:Here's the case I mentioned in #7

I'm not sure this case applies here. The commissioner and the taxpayer are arguing over whether the IRS can reach back into closed years and cause the taxpayer to recognize income that has already been determined not to be a contribution to capital in those years.

Jeff-Ohio wrote:Isn’t another (potential) complication the new tax law…the revision to Sec 118?

Only if the changes are retroactive to all of 2017. Are they?
 

#13
Chay  
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It looks like they aren't:

(1) IN GENERAL.—Except as provided in paragraph (2), the amendments made by this section shall apply to contributions made after the date of enactment of this Act.
(2) EXCEPTION.—The amendments made by this section shall not apply to any contribution, made after the date of enactment of this Act by a governmental entity, which is made pursuant to a master development plan that has been approved prior to such date by a governmental entity.
 

#14
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I'm not sure this case applies here.. Me neither, either, or too. I was kind of changing the subject a bit.
 

#15
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Only if the changes are retroactive to all of 2017. Are they?


No. See Post #5, including the importance of dates, which were not provided.
 

#16
Coddington  
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The dates in the OP included an August date, IIRC It is July, so this is entirely hypothetical or happened no later than 2017.
-Brian

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SourceAdvisors.com

Opinions my own.
 


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