Refund of State Tax Credit in Excess of Tax Liability is Taxable Income

In March of 2015 we discussed a Tax Court case holding that various refundable New York state income tax credits represented income to the taxpayers involved in the case of Maines v Commissioner, 144 TC No. 8.[1]  In Ginsburg v. Commissioner, CA FC, Case No. No. 1:17-cv-00075-RHH a different taxpayer decided to go a different route to obtain relief, bringing their case in the Court of Federal Claims.

Unfortunately for the taxpayer, the results turned out to be the same (the excess was taxable) and when they appealed that decision to the Court of Appeals for the Federal Circuit, they were denied relief at that level as well.

In this case, the issue involved Brownfield Redevelopment Tax Credits offered by the state of New York.  As the Circuit Court opinion notes:

In 2005, the Ginsburgs, through Hawthorne Village, LLC (“Hawthorne”), a corporation in which the Ginsburgs indirectly hold a majority of the partnership interests, acquired property located at 220 Water Street in Brooklyn, New York (“the property”). J.A. 269.2 After the Ginsburgs applied to participate in the Brownfield Cleanup Program, NY DEC approved their application and the parties entered into a Brownfield Site Cleanup Agreement. See J.A. 186-213. “The development of [the property] started in 2005 and was completed in 2011,” thereby converting what was once an old shoe factory into a residential rental building. J.A. 102; see J.A. 103. In 2011, the Ginsburgs granted an environmental easement to the State of New York. J.A. 411-17. A few months later, NY DEC issued a certificate of completion. J.A. 258-59; see J.A. 256-57.

Hawthorne applied for a brownfield redevelopment tax credit of $6,583,835.10 for tax year 2011, see J.A. 276-79, with the Ginsburgs’ share of that credit equaling $4,975,595.00, J.A. 526. In 2013, the State of New York paid the Ginsburgs a refund of $1,903,951.00 attributable to the brownfield redevelopment tax credit. See J.A. 353, 370. They did not report this payment as part of their income on their 2013 federal income tax return, claiming instead that this payment constituted a nontaxable refund. See J.A. 272, 370. After exercising its authority under the Internal Revenue Code to conduct an examination, see I.R.C. § 7602(a) (2012), the Internal Revenue Service (“IRS”) proposed adjustments to the Ginsburgs’ 2013 income taxes, by including as taxable income $1,864,618.00 of the $1,903,951.00 excess amount paid by the State of New York, J.A. 504; see J.A. 504 & n.9 (explaining that the IRS found only the $1,864,618.00 portion was taxable after accounting for “state tax withholdings” and “estimated state tax payments”). As a result of these proposed adjustments, the IRS determined the Ginsburgs owed an additional $690,628.46 in federal income tax, which the Ginsburgs paid. See J.A. 390.

The appellate panel summarized the trial court’s decision that the net refund represented taxable income as follows:

The Court of Federal Claims explained that “the excess [b]rownfield credit was nothing more than a cash transfer from [New York] to the [Ginsburgs],” and the payment “is, substantively, an undeniable accession to wealth over which [the Ginsburgs] have complete dominion.” Id. According to the Court of Federal Claims, “New York’s payment came with no strings attached,” meaning “[the Ginsburgs] were free to spend, save, or transfer the excess credit in whatever way they pleased.” Id.

The Court of Federal Claims disagreed with the Ginsburgs that the brownfield redevelopment tax credit qualified for certain “exceptions or exclusions” to federal income tax liability. Id. at 5. Specifically, the Court of Federal Claims rejected the Ginsburgs’ “theory that the [b]rownfield credit is a recovery of capital and thus not income” because “[the Ginsburgs] have not sold or transferred any of their capital assets” and “[n]o ‘recovery’ has yet occurred because [their] capital investment is still ongoing.” Id. The Court of Federal Claims similarly rejected the Ginsburgs’ theory of inducement stating that, “while the [b]rownfield project provided an investment incentive to [the Ginsburgs], no inducement by the [S]tate of New York occurred.” Id. Instead, the Ginsburgs “freely chose to participate and take advantage of New York’s state tax credit program.” Id.

The appellate panel considered the taxpayers’ arguments for excluding the excess refund from income that the trial court had rejected.  The taxpayers argued that the payments were simply a reimbursement of the capital costs of cleaning up and redeveloping the property. As well, they claimed there so many strings attached that they did not have true control over the amounts they received as excess tax credits.

The appellate panel did not agree with this view.  First, they rejected the view that this was merely a reimbursement of costs, thus not taxable as a return of capital.  The panel’s opinion held:

…[T]he excess amount is an “undeniable accession[ ] to wealth.” Glenshaw Glass, 348 U.S. at 431. After using the brownfield redevelopment tax credit to offset the Ginsburgs’ state tax liability, the State of New York paid them $1,864,618.00 as the remainder of the tax credit. See J.A. 504; see also J.A. 353, 370. The Ninth Circuit’s holding in Baboquivari Cattle Co. v. Commissioner is instructive. 135 F.2d 114 (9th Cir. 1943). There, a cattle rancher made improvements to ranch lands leased from the state of Arizona, including rebuilding “dirt reservoirs and earthen tanks” to prevent “erosion.” Id. at 115. Pursuant to a federal statute, the United States made two payments to the rancher for “completion” of the work, with the “cost of the work to [the rancher] in each year exceed[ing] the amounts received.” Id. The Ninth Circuit rejected the rancher’s argument that the payments were nontaxable “capital subsidies” for “positive outlays,” rather than “income subsidies.” Id. The Ninth Circuit found no “justification for these . . . distinctions,” concluding instead that these federal payments were taxable income, where the “beneficiary does not earn a payment merely by making an improvement” but instead “earns it in part by compliance with conditions in respect of the proper use of [the] land.” Id. at 116. Similarly, the excess amount of the state tax credit (after offsetting for state tax liabilities) paid to the Ginsburgs, based on their positive outlays in redeveloping a brownfield site, is “an economic gain” made for compliance with the Brownfield Cleanup Program and is includable in gross income. Comm’r v. Banks, 543 U.S. 426, 433 (2005); see Maines v. Comm’r, 144 T.C. 123, 136 (2015) (holding that the “excess portion [of a state tax credit] that remains after first reducing state-tax liability and that may be refunded is an accession to the [taxpayers’] wealth, and must be included in their federal gross income”).

The Court rejects the “return of capital” theory, continuing:

Even though the brownfield redevelopment tax credit is calculated, in part, based on costs incurred by the taxpayer, such as “[s]ite preparation” and “[t]angible property” costs, see N.Y. Tax Law § 21(a)(2), (3), we do not agree that this renders the paid excess amount of the credit a nontaxable return of capital. A treatise on federal income tax explains the return of capital theory: “[w]hen the purchaser’s obligations are received as part of the consideration on a sale but have no ascertainable fair market value at the time of their receipt, the seller may treat the full amount of the payments as they are received as a return of capital” and that “[o]nly those payments that are received after his entire basis has been recovered must be reported as income.” 1 Mertens, Law of Fed. Income Taxation § 5:10 (2019); see 1 Bittker & Lokken, Fed. Taxation of Income, Estates and Gifts, ¶ 5.4 (2019) (explaining that gain is not realized where the “payment served only to restore the taxpayer’s impaired capital”).6 Here, however, the Ginsburgs neither allege that a payment was made to New York, nor explain why the payment of the excess amount of the brownfield redevelopment tax credit is a return of their basis to restore impaired capital. See generally Appellants’ Br. Instead, the developer, Hawthorne, not the Ginsburgs, directly invested in the development of the brownfield site, including cleanup, see J.A. 102, and the Ginsburgs received a portion of the brownfield redevelopment tax credit that was paid by the State of New York to Hawthorne, see J.A. 526. As the Court of Federal Claims recognized, Hawthorne’s “capital investment” in the property “is still ongoing.” Ginsburg, 136 Fed. Cl. at 5. Under these circumstances, the Ginsburgs have failed to meet their “burden of proving that money received . . . represents a recovery of capital, rather than ordinary income.” Morse, 371 F.2d at 483.

The opinion continues to reject a “reimbursement of costs” defense in more detail:

The Ginsburgs aver they were induced “to cleanup and redevelop” the property and therefore the excess amount of the brownfield redevelopment tax credit is a nontaxable reduction in their cost basis, rather than taxable income. Id. at 37.7 In Freedom Newspapers, the U.S. Tax Court held that a broker’s payment to a taxpayer was a nontaxable reduction in cost basis, where the broker “induce[d the taxpayer] to purchase” an additional newspaper as part of its purchase of a group of other newspapers by promising to pay the taxpayer $100,000.00 if the broker was unable to resell the additional newspaper within a year. 36 T.C.M. (CCH) at 1755; see id. at 1757-58. Similarly, in Brown, the Board of Tax Appeals held that a majority stockholder’s payment to a taxpayer for the purposes of persuading the taxpayer to purchase stock in the same company was a nontaxable reduction in cost basis for the taxpayer’s stock purchase because the majority stockholder induced the purchase. See 10 B.T.A. at 1054. By contrast, the State of New York here does not hold a financial interest in the Ginsburgs’ purchase similar to either the broker in Freedom Newspapers or the majority stockholder in Brown. See Freedom Newspapers, 36 T.C.M. (CCH) at 1757-58; Brown, 10 B.T.A. at 1054. Nor did New York enter into negotiations with the Ginsburgs to induce them into cleaning up the brownfield site. Instead, we agree with the Court of Federal Claims that the Ginsburgs “freely chose to participate and take advantage of New York’s state tax credit program.” Ginsburg, 136 Fed. Cl. at 5; see N.Y. Tax Law § 21. We decline to extend the common law inducement doctrine to this case given these circumstances.

As well, the court found the Ginsburgs had complete control over these refunded amounts, noting:

In Baboquivari, the Ninth Circuit recognized that “[n]o part of the sums paid to the [rancher] were required to be placed by him in a particular account or fund” and “[t]he payments were not earmarked” or their use otherwise “restrict[ed],” even though “the right to have or retain the subsidy for the improvement” could be “defeated” for failure to “compl[y] with conditions in respect of the proper use of [the] land.” 135 F.2d at 116 (emphasis added). Likewise, there were no restrictions on the Ginsburgs’ use of the excess amount of the tax credit and the Ginsburgs were “free to use the money for any purpose [they] might see fit.” Id. Even though New York could revoke the certificate of completion for, inter alia, lack of continued compliance or a discovery that the Ginsburgs made a misrepresentation of material fact, see N.Y. Envtl. Conserv. Law § 27-1419(5), the avoidance of this potential revocation is within the Ginsburgs’ control and therefore does not “depend[ ] on events outside of [their] control,” Hous. Indus. Inc. & Subsidiaries v. United States, 125 F.3d 1442, 1445 (Fed. Cir. 1997) (citation omitted). Moreover, although New York’s law contemplates revocation of a certificate of compliance where “[t]here is good cause,” N.Y. Envtl. Conserv. Law § 27-1419(5)(d), we do not believe that this alone is sufficient to hold that the Ginsburgs lacked complete dominion and control, see Indianapolis Power & Light, 493 U.S. at 210 (requiring “some guarantee” to satisfy the complete dominion and control condition, rather than an absolute guarantee). We conclude that the Ginsburgs have complete dominion and control over the payment because there is a legally — adequate guarantee that they will be allowed to keep the excess amount of the tax credit, barring actionable misconduct on their part.

[1] “State’s Label of Refundable Credits as Overpayments of State Income Tax Not Binding on Federal Courts,” Current Federal Tax Developments website, 3/13/2015,