Thursday, March 10, 2011

Non-Corporate Entities Can't Rely On Code Sec. 118 To Exclude Contributions From Non-Owners

IRS Appeals Settlement GuIRS Appeals Settlement Guidelines, “Exclusion of Income: Non-Corporate Entities and Contributions to Capital”

In recent Appeals Settlement Guidelines (ASGs), IRS has reiterated its position that non-corporate entities can't rely on Code Sec. 118 or any common law contribution to capital doctrine to exclude from gross income funds or properties received from non-owners. IRS concluded that, based on the plain language of the statute, the doctrine of preemption, and other factors, its risks in litigating this position were minimal.

Background. In general, gross income is broadly defined by Code Sec. 61(a) as including “all income from whatever source derived.” However, Code Sec. 118(a) provides an exception to that rule under which a corporation doesn't include in gross income any contribution to its capital. Under Reg. §1.118-1, a contribution to capital can be made by persons other than shareholders. For example, the value of land or other property contributed to a corporation by a governmental unit or a civic group to induce it to locate its business in a particular community, or enable it to expand its operating facilities, is excludable. However, any money or property transferred to a corporation in consideration for goods or services rendered isn't excludable.

In addition to the statute itself, courts also look to common law in evaluating nonshareholder contributions to capital. Notably, in U.S. v. Chicago, Burlington & Quincy Railroad Co, (1973, S Ct) 32 AFTR 2d 73-5042, 412 US 401, the Supreme Court set out a number of characteristics of a qualifying nonshareholder contributions to capital, including that it must become a permanent part of the transferee's working capital structure; it can't be compensation, e.g., a direct payment for a specific, quantifiable service provided for the transferor by the transferee; and it must be bargained for.

IRS (Compliance) position. In a 2008 Coordinated Issue Paper (CIP), IRS determined that partnerships and other non-corporate entities couldn't exclude from gross income amounts received from a non-owner under Code Sec. 118(a) or any common law contribution to capital doctrine. The CIP asserted that, in enacting Code Sec. 118(a), Congress codified the existing case law and effectively preempted the issue of excluding capital contributions from the gross income of partnerships and non-corporate entities. In response to the CIP, IRS received a number of comments from stakeholders which, in combination with other taxpayer protests, were used to articulate the various arguments against IRS's position.

Industry/taxpayer position. The position taken by taxpayers (i.e., those operating in non-corporate form) and other stakeholders was that, so long as the transfer of funds or property constitutes a contribution to capital under the criteria established in case law (such as the Chicago, Burlington factors set out above), it does not matter whether the entity receiving the funds or property is a partnership or other non-corporate entity. This “common law contribution to capital doctrine” argument has been asserted by taxpayers in cases involving Universal Service Fund payments, federal, state and local subsidies, grants, and other types of inducement payments. The taxpayers effectively claimed that, even if non-corporate entities didn't fall within Code Sec. 118(a), capital contributions to such entities nonetheless qualified for exclusion under the common law doctrine.

Observation: ASGs are written by Appeals and reviewed by the Office of Chief Counsel to ensure consistent resolution of issues nationwide. Appeals will generally develop settlement guidelines when an issue is coordinated by the Examination function, which then works with Deputy Area Counsels to develop a CIP. Settlement guidelines build on the CIP by addressing issues such as the hazards of litigation.

Analysis. IRS Appeals examined pre- Code Sec. 118 case law regarding non-shareholder contributions to capital, the plain language of the statute and its legislative history, and the doctrine of preemption and ultimately agreed with the position taken in the CIP.

In Edwards v. Cuba Railroad, (1925 S Ct) 5 AFTR 5398, which was the first major case dealing with non-shareholder contributions to capital, the Supreme Court held that a government subsidy provided towards construction of a railroad was not includible in the railroad's income. However, this provided an opportunity for corporations to receive a double benefit from such contributed property—in that the recipient corporation not only received the property free from income tax, but also received the contributors' basis in the subject property and could claim depreciation deductions for that amount. In’54, Congress removed the potential for a double benefit by: (i) enacting Code Sec. 118(a), which codified existing case law providing for an exclusion from income of certain capital contributions to corporations; and (ii) enacting Code Sec. 362(c), which reversed other case law and related statutory provisions regarding basis.

Appeals further found that, in addition to the plain language of Code Sec. 118(a), which itself doesn't extend income exclusion beyond corporations, the legislative history further supports the position set forth in the CIP. Specifically, S. Rep. No. 83-1622, at 4648 (1954) stated that “in the case of a corporation, gross income is not to include any contribution to the capital of the taxpayer.”

Appeals then turned to the issue of whether Code Sec. 118(a) preempted a partnership's (or other non-corporate entity's) claim to exclude nonshareholder capital contributions from gross income. The CIP cited as authority Commissioner v. Kowalski, (1977 S Ct) 40 AFTR 2d 77-6128, and In re Chrome Plate, (1980 CA5) 45 AFTR 2d 80-1241, both of which involved instances where a common law-based argument (i.e., a judicially-developed rule that had been applied prior to the enactment of a certain statute) “gave way” to the statute. In both cases, the Court determined that Congress was aware of, and intended to modify and/or replace, the earlier rules.

The taxpayers, however, asserted that the Supreme Court's silence regarding the treatment of other entity forms does not preempt the application of the common law contribution to capital doctrine to non-corporate entities. Their specific arguments, and Appeals' rebuttal of each, are as follows:

... The double benefit issue that Code Sec. 118 and Code Sec. 362(c) were enacted to address isn't implicated by extending Code Sec. 118 to non-corporate entities. The taxpayers claimed that, because there was no longer any double benefit issue, no inference could be drawn that the enactment of these sections negated the common law doctrine regarding non-shareholder contributions to capital. Appeals noted, however, that the plain language of Code Sec. 118 and Code Sec. 362(c) addresses only corporations—regardless of whether other non-corporate entity types were simply disregarded or intentionally excluded.

... Code Sec. 118 doesn't expressly limit the application of the common law doctrine to corporations. The taxpayers argued that, absent an express statement that the statute intended to remove any rights from the non-corporate taxpayer, the common law contribution to capital doctrine remains in effect. Appeals rejected this argument, stating that even though the common law criteria used to evaluate a contribution isn't specific to any particular entity, non-corporate entities still fall outside of the plain language of Code Sec. 118.

... The expanded definition of “gross income” didn't eviscerate Cuba Railroad. The taxpayers claimed that Cuba Railroad, in which the Supreme Court held that contributions to capital are not income, has never been overruled and continues to be cited. However, Appeals stated that the constitutional basis underlying Cuba Railroad has been eroded by the expanded definition of “income.” Also, the “functional use” test set out in Cuba Railroad, which examines the subsidy's function to determine whether it reflects a reimbursement of capital expenditures, has been effectively replaced by the “contributor motivation” test, under which the intent of the contributor is used to determine whether the payments represented contributions to capital.

... General inducements are not income. The taxpayers argued that some inducements, such as purchase price adjustments, aren't income regardless of to whom they are payable (i.e., they are reflected instead as a reduction to the basis of the acquired property). Appeals stated that this argument didn't provide any support for excluding inducements received by non-corporate entities under the common law. Appeals also easily distinguished the “general inducement principle” as involving a sales transaction between private parties and resulting in a direct benefit to the payor.

Conclusion. Appeals determined non-corporate entities can't rely on Code Sec. 118 or common law-based arguments to exclude funds or properties received from non-owners from gross income. Such a position is contrary to the plain language of Code Sec. 118(a), unsupported by pre- Code Sec. 118(a) cases that didn't address the form of the entity, and would likely fail in light of the Chrome Plate and Kowalski decisions. Thus, Appeals concluded that the chances of a court applying the common law definition of a “nonshareholder contribution to capital” to non-corporate entities and allowing an exclusion from income were slim.

Appeals also noted that a taxpayer clearly chooses the type of entity and is thus bound by the tax consequences of that choice, regardless of whether or not such consequences were intended. So, by choosing to operate as a non-corporate entity, a taxpayer has placed itself out of Code Sec. 118(a)’s exclusion.

References: For nonshareholder contributions of property to a corporation, see FTC 2d/FIN ¶F-1903.1; United States Tax Reporter ¶1184.01; TaxDesk ¶232,308; TG ¶11437.

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