Are State and Local Economic Incentives Taxable?

States and local governments often use a variety of incentives to promote economic growth and redevelopment, including cash grants, land grants, tax abatements, and infrastructure financing. During the COVID-19 pandemic, state and local governments have also provided grants and incentives to businesses to aid in their survival.

These incentives have historically been tax-free, but amendments to IRC Section 118 have made grants taxable as income under the federal tax code as well as under conforming state tax codes. Congress amended Section 118 to remove what they perceived as a federal tax subsidy for state economic programs. The changes have reduced the overall value of these incentives for taxpayers and could have an impact on how states structure these programs.

TCJA Amendments to Section 118

IRC Section 118(a) provides that “gross income does not include any contribution to the capital of the taxpayer.” Prior to passage of the Tax Cuts and Jobs Act (TCJA), Section 118 applied to contributions to capital by governmental entities. Section 118 excluded from income “the value of land or other property contributed to a corporation by a governmental unit or by a civic group for the purpose of inducing the corporation to locate its business in a particular community, or for the purpose of enabling the corporation to expand its operating facilities.” The TCJA, however, added an exclusion in Section 118(b)(2) for “any contribution by any governmental entity or civic group (other than a contribution made by a shareholder as such)” from this definition of a “contribution to the capital.”

The new exclusion applies to contributions made after the amendment’s December 22, 2017 date of enactment. The amended section, however, does not apply to any government contribution made after the date of enactment pursuant to a master development plan that the government entity approved before the date of enactment.

Federal, state, or local governments must file Form 1099-G to report payments for state or local income tax refunds, credits, or offsets, or payments for taxable grants.

Economic Development Incentives

The Section 118 change applies to incentives that are government “contributions.” This includes an array of grants and tax reimbursements but excludes nonrefundable tax credits, tax deductions, tax abatements, and exemptions. This change affects a number of economic development programs in Texas, including Chapter 380 and Chapter 381 Economic Development Agreements for local and county governments, enterprise zones, and tax increment financing (TIF) grants.

• Texas Economic Development Agreements: Chapter 380 of the Local Government Code allows municipalities to offer incentives in the form of loans and grants to promote economic development. Chapter 381 allows counties to offer these types of loans and grants and allows counties to offer tax abatement agreements.
• Texas Enterprise Zone Program: The Texas Enterprise Zone Program provides for local communities to partner with the state to promote investment and job creation in economically distressed areas. This can include such incentives as refunds for state sales and use tax on certain expenditures, tax abatement, tax increment financing, and easier permitting.
• Tax increment financing (TIF) grants: Tax increment financing (TIF) grants are property tax incentives used to subsidize redevelopment, infrastructure, and other community-improvement projects within a defined geographical area.

For Texas taxpayers, Section 118 does not apply for purposes of the Texas Franchise Tax, as Texas conforms to the Internal Revenue Code in effect for tax years beginning on January 1, 2007.

Alternatives

While the need for state and local governments to promote economic growth and redevelopment persists, the taxability of some of these incentives could prompt governments to change existing programs to improve their attractiveness to taxpayers. Governments could restructure grants as nonrefundable tax credits, deductions, abatements, or exemptions. In the meantime, taxpayers should examine these programs to understand their options and the different tax consequences of receiving incentives as loans and grants or tax credits and abatements.

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