BGBC Partners, LLP Tax Update: Receipt of Non-Taxable Grants
When businesses operating as corporations are seeking to relocate or expand, an often- overlooked funding source is a direct contribution by a city or county. Government entities or other community groups may have an interest in attracting a grocery store to underserved areas in their community, and are often willing to pay grant money as an incentive to get the business there.
If the funds are contributed to the capital of the corporation, the funds may qualify for a little-known taxable income exclusion in the tax code, and this exclusion is the topic for this week’s Tax Update.
Section 118 of the tax code was enacted to encourage public-private community ventures by providing a taxable income exclusion for capital infusions by government agencies. It is very important to note that this exclusion only applies to corporations and not partnerships or other legal entity structures. In addition, the exclusion results in a corresponding reduction in the tax basis of the related property which may result in reduced depreciation deductions.
The theory behind the nontaxability of these grants is that the grant is similar to a nontaxable shareholder contribution to capital. The receipt of these kinds of grants are considered non-shareholder contributions to capital if they meet certain criteria. Typically, contributions are made by shareholders, but these non-shareholders contributions are viewed by the tax code as equity and not taxable income.
Grants are typically given to benefit the community that the corporation operates in. When receiving grant money, the Courts have established a five-part test to determine whether a non-shareholder payment to a corporation can be considered a contribution of capital and therefore not taxable.
The prongs of the five-part test are as follows:- The payment must become a permanent part of the corporations working capital
- The payment must not be compensation for specific goods or services
- The payment must be bargained for.
- The payment must result in a benefit to the taxpayer commensurate with its value, and
- The payment must be employed in or contribute to the production of income.
As noted above, the basis of related property is reduced which can reduce depreciation deductions. Therefore, if a store-owner receives a $100,000 grant to build a store in a certain community, the grant is excluded, but the building is reduced by the $100,000.
Consequently, the numbers should be crunched to determine if this strategy is a fit.
This is an opportunity that is available if the right set of circumstances are present. If carefully structured, a store or other business owner and a surrounding community may both benefit. However, an experienced CPA should be consulted to ensure that a particular project qualifies for the exclusion and that the existing tax rules and regulations are complied with.