Not all government subsidies are tax free

Many companies receive significant federal, state or local government subsidies.

These subsidies can take the form of:

• Payments of cash.
• Donations of land or buildings.
• Loans with no expectation of repayment.
• Tax increment financing.

Most companies expect that these subsidies are tax free. After all, it would seem irrational for a government to offer a subsidy and simultaneously demand a portion of that subsidy back in taxes.

However, a controversial memo issued last year by the IRS suggests that partnerships and LLCs should pay income tax on government subsidies.

Supreme Court ruling

A string of U.S. Supreme Court cases in the early 1900s held that a government subsidy was tax-free to a corporation. These cases held that property purchased with the subsidy had a tax basis equal to the amount paid for the property. Thus, the corporation received a dual tax benefit.

For example, a manufacturer could build a new factory with tax-free cash received from TIF financing, and then claim depreciation deductions on this factory to offset taxable income.

To prevent this dual tax benefit, Congress passed a law in 1954 stating that while a subsidy to a corporation (including S-corporations) is tax free, the tax basis of any property purchased with the subsidy is zero.

This 1954 law addresses only corporations, but not partnerships or LLCs. This is not surprising.

In 1954, LLCs had not yet been invented, limited partnerships were relatively new, and almost no large business was conducted as a general partnership.

Explanation needed

Frustratingly, Congress and the IRS have yet to issue official guidance explaining the tax consequences of a subsidy to a partnership or LLC. Consequently, many LLCs and partnerships have assumed for decades that a government subsidy is tax free, relying in part on the logic of the Supreme Court cases from the early 1900s.

After years of silence, in October 2007, the IRS published a memo to its auditors, suggesting that they should challenge LLC and partnership tax returns that claim that a government subsidy is tax free.

The memo explains that the IRS now thinks these subsidies are taxable. This memo acknowledges that it is not an official pronouncement of law, but rather the opinion of one branch of the IRS.

Flawed position

Many tax advisers believe this IRS position is flawed. Nonetheless, if IRS auditors follow this memo, partnerships or LLCs that receive subsidies are at risk of being challenged by the IRS. As noted above, this is not a concern for corporations, which enjoy the clarity of the 1954 law.

A partnership or LLC has several alternatives to deal with this tax risk.

• First, the company can ignore the IRS memo as unofficial and incorrect, and be prepared to fight the IRS if necessary.
• Second, the company can convert to a corporation to enjoy the clarity of the 1954 law for future subsidies.
• Third, the company can restructure its operations to receive future subsidies in a manner tax free under the 1954 law.
• Fourth, the company can amend its tax returns prior to being audited by the IRS.

In summary, partnerships and LLCs should not assume that a subsidy from the government is tax free.

The proper alternative will vary from company to company, and should be based on a discussion with a company's tax adviser.

Hamang B. Patel is an attorney with Michael Best and Friedrich.