The Eleventh Circuit Court of Appeals upheld a Georgia district court decision holding that federal and state incentive payments to a local telephone company were gross income. The appellate court accepted the lower court’s analysis that the payments were not excludable as nonshareholder capital contributions.
IRC § 118(a) excludes from income taxpayer contributions to capital. Treas. Reg. § 1.118-1 states that the exclusion also applies to nonshareholder contributions. It provides an example in which the value of land given by a government to a company to locate its business there is excluded from income, but money or property given in return for goods or services is included. The Supreme Court in U.S. v. Chicago, Burlington & Quincy Railroad Co. (32 AFTR2d 73-5042), stated in 1973 that the intent or motive of the nonshareholder transferring the property determines whether the amount is excluded from income. The high court also listed five characteristics of nonshareholder capital contributions: The payment must become part of the recipient’s permanent working capital, may not be made in return for an identifiable service, must be bargained for, must result in a benefit to the recipient in an amount roughly equal to the payment and will be used to produce additional income.
In 1998, Coastal Utilities Inc., a local telephone company in southeastern Georgia, received payments from the Federal-State Joint Board on Universal Service, which operates under the jurisdiction of the Federal Communications Commission. The payments were received under federal programs that encourage telecommunication companies to extend their infrastructure into areas they wouldn’t otherwise consider because of high fixed costs and few customers. The company also received payments from Georgia to recover lost revenues due to mandated reductions in certain customer fees. All payments were initially included as income on Coastal’s tax return, but the company later received a refund when it filed an amended return excluding them. In 2004, the U.S. government filed suit in the U.S. Southern District Court of Georgia to recover that refund.
Coastal argued that the payments were contributions to capital since they were made for a public purpose and not in exchange for any specific good or service. The court rejected this argument, stating that a government payment made for a public purpose does not automatically qualify as a capital contribution; the intent of the government must be considered, in this case, a supplement to income. The payments were based on Coastal’s expenses to provide a rate of return and thus were an incentive for the company to invest in infrastructure as opposed to a direct payment for that infrastructure, the court said.
U.S. v. Coastal Utilities, Inc., 101 AFTR2d 2008-836
By Charles J. Reichert, CPA, professor of accounting, University of Wisconsin–Superior.