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Portions of Refundable State Tax "Credits" Were Includable in Federal Income.

(Parker Tax Publishing March 17, 2015)

The Tax Court held that taxpayers had to include in income portions of refundable state tax "credits" received from participating in a New York economic development program. The court found that, contrary to the state's characterization, the refundable credits were effectively taxable subsidies. Maines v. Comm'r, 144 T.C. No. 8 (3/11/15)

Background

The New York Empire Zones Program (EZ Program) provides incentives for businesses to stimulate private investment and business development, and tries to create jobs in impoverished areas in New York State. David and Tami Maines received these incentive payments from their participation in the EZ Program between 2005 and 2007 through their two passthrough entities, Endicott Interconnect Technologies, Inc., and Huron Real Estate Associates.

New York calls these payments "credits" and treats them as refunds for "overpayments" of state tax. All the credits required the Maines to make some amount of business expenditure or investment in targeted areas within the state. One of the credits, the QEZE Real Property Tax Credit, is limited to the amount of past real property tax actually paid. The other two credits, the EZ Investment Credit and the EZ Wage Credit, are not limited to past tax actually paid. All the credits first reduce a taxpayer's state income-tax liability; any excess credits may be carried forward to future years or partially refunded.

For 2005 to 2007, the Maines eliminated their state income-tax liability primarily through the use of other nonrefundable state credits. Because the Maines had little to no state income-tax liability in these years for the credits to offset, the refundable credits under the EZ program led to large "refund" payments from New York, which the Maines did not include on their federal income tax returns.

The IRS assessed deficiencies for 2005 to 2007, arguing that the refundable credits were, in substance, cash subsidies constituting taxable income, and the Maines challenged this determination in the Tax Court.

Analysis

State tax refunds are not income unless the taxpayer claimed a deduction for them, for example, by itemizing for the previous year (Tempel v. Comm'r, 136 T.C. 341 (2011)). Likewise, under the tax-benefit rule, a taxpayer is allowed to exclude a refund from his income only if he never got the benefit of a corresponding deduction for an earlier year (Hillsboro Nat'l Bank v. Comm'r, 460 U.S. 370 (1983)).

The Maines claimed they took no deduction on their federal income-tax returns for 2005 to 2007 for state income tax paid in the preceding years, arguing their refunds should not be included in their income under the tax benefit rule. They pointed out that their credits under the EZ Program were defined by New York state law to be "overpayments" of state income tax.

However, the Tax Court noted that the state-law label of the credits as "overpayments" of past tax was not controlling for Federal tax purposes; if that were true, a state could undermine federal tax law simply by including certain descriptive language in its statute. The court quoted Abraham Lincoln, reasoning that under the Maines' logic, "if New York called a tail a leg, we'd have to conclude that a dog has five legs in New York as a matter of federal law." Instead, the court looked to the nature of the credits to determine whether they were non-taxable refunds of overpaid state taxes.

The court observed that to qualify for the EZ Investment Credit and the EZ Wage Credit, taxpayers must own a business with property in a designated Empire Zone and have full-time employees receiving qualified EZ wages. Neither of the credits depended on a refund of previously paid state taxes deducted under federal law and instead were essentially cash subsidies from the state to incentivize taxpayers.

The court held that the portions of the EZ Investment Credits and the EZ Wage Credits that actually reduced the Maines' state-tax liabilities were not taxable income. However, any excess portions of the credits that were refundable were taxable income.

In contrast, the court noted that taxpayers receive a QEZE Real Property Tax Credit only if their business pays eligible real-property taxes, and the amount of the credit cannot exceed the amount of those taxes actually paid. Thus the refundable portion of the credit could be treated like a refund of past overpayments.

The court held the portions of the QEZE credit payments that only reduced the Maines' state-tax liabilities were not taxable income. However, the refundable portions of the credit were includible in the Maines' gross income under the tax-benefit rule to the extent that they had taken previous deductions for property-tax payments.

For a discussion on the recovery of tax benefit items, including state tax credits, see Parker ¶76,900. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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