Refundable state business tax credits are income

Refundable state income tax credits designed to promote economic development are taxable income to the recipients.
By Charles J. Reichert, CPA

The Tax Court held that the refundable portion of New York state business incentive tax credits was taxable income. Although the state of New York created the right to the credits and labeled them as overpayments of state income tax, federal law determines how the rights should be taxed, according to the court.

Facts: David and Tami Maines owned Endicott Interconnect Technologies Inc., an S corporation, and Huron Real Estate Associates, a limited liability company taxed as a partnership. From 2005 to 2007, the entities operated in an Empire zone, an economic development zone established by New York to create jobs in impoverished areas of the state. Businesses that operated in an Empire zone could qualify for certain refundable state tax credits. Endicott and Huron qualified for the EZ investment credit, which was based on the cost of qualifying property placed in service in the Empire zone, and the EZ wage credit, which was based on satisfying certain employment requirements. Huron also qualified for the qualified Empire zone enterprise (QEZE) real property tax credit, a state income or corporate franchise tax credit based on the amount of real property taxes it paid.

The Maineses reported their distributive shares of the refundable credits on their New York state income tax returns from 2005 to 2007, eliminating their New York income tax liabilities for those years. Due to the credits' refundable feature, they received refund checks despite having no New York state withholding or estimated state payments for those years. Because New York called the credits overpayments of state income tax and because the Maineses had never taken a deduction for state income tax on their federal returns, the taxpayers excluded the refunds as income on their federal returns for the years. During the tax years at issue, Huron deducted on its federal returns local property tax payments as a rental business expense, reducing income passed through to the Maineses. The IRS issued a deficiency notice based on its determination that the refunds were income.

Issues: Taxpayers' gross income includes any increase in wealth unless it is specifically excluded. The tax-benefit rule requires taxpayers to recognize gross income when, in a later year, they recover an item deducted in a previous year if that item had reduced their federal income tax liability. The IRS argued that the QEZE real property tax credit was income under the tax-benefit rule and the other two credits were gross income because they increased the taxpayers' wealth and there was no applicable exclusion.

The taxpayers argued that the refundable portion of the QEZE real property tax credit was not gross income under the tax-benefit rule because Huron, not they, had deducted the real property taxes that created the credit.

Holding: The Tax Court held the refundable portion of the QEZE real property tax credit was gross income under the tax-benefit rule because the Maineses received a tax benefit when their distributive share of Huron's income was lower due to Huron's property tax deduction.

The court held that the tax-benefit rule did not apply to the refunds of the EZ investment credit and the EZ wage credit. Although New York state law labeled the refundable portions of the credits as overpayments of tax, this label was not controlling for federal tax purposes. The court found that under federal law, the refunds were not "a refund of previously paid state taxes deducted under federal law"; rather, they were transfers from New York to the taxpayers, which the court called "essentially subsidies."

Thus, the court determined that the refundable parts of the two credits increased the taxpayers' wealth and, unless a specific exclusion applied, they must be included in gross income. Because the Maineses had not paid any state income tax in the years in question, the court rejected their argument that the refundable tax credits were excludable returns of capital. The taxpayers also argued that the credits were excludable under the general-welfare exclusion that applies to payments such as food stamps and heat assistance payments. However, the court observed, the general-welfare exclusion requires a payment from a government fund that promotes the general welfare (generally based on need) that is not compensation for services, and the payments to the taxpayers were not based on need.

—By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota–Duluth.

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