The case of Thermal Circuits, Inc. v. Commissioner, T.C. Memo. 2026-29, centers on a manufacturing corporation that received substantial funds from a customer to expand its production capacity. Thermal Circuits, Inc. (Thermal), an accrual-method C corporation, manufactures foil heating components. In 2013, Nicoventures Trading Limited (NVT), a subsidiary of British American Tobacco, engaged Thermal to produce foil heating elements for electronic tobacco devices.

By 2016, NVT’s demand for the heaters significantly outpaced Thermal’s production capacity. NVT desired nearly 20 times the output without an increase in the $10 per-unit cost. To meet this volume at a fixed cost, Thermal needed a larger facility and more equipment. NVT ultimately agreed to fund an expansion of Thermal's leased manufacturing facility. In 2017, NVT paid $4.085 million toward the leasehold addition, followed by an additional $204,529 in 2018. Throughout construction, Thermal purchased necessary tools and machinery to populate the addition, billing NVT on a cost-plus basis. Once completed, Thermal paid the insurance and property taxes for the entire premises, including the new addition, and bore all attendant risks.

The Taxpayer's Request for Relief

Thermal did not report the $4.3 million received from NVT as taxable income on its 2017 or 2018 Form 1120. Attached to its 2018 return, Thermal included a Form 8275, Disclosure Statement, asserting that the funds represented a non-shareholder contribution to capital excludable from gross income under Internal Revenue Code (I.R.C.) Section 118(a). Furthermore, Thermal relied on the five-part test established by the Supreme Court in United States v. Chicago, Burlington, & Quincy Railroad Co. (CB&Q), 412 U.S. 401 (1973) to support its exclusion.

The Commissioner issued a Notice of Deficiency determining tax deficiencies of $1,277,147 for 2017 and $42,951 for 2018, alongside Section 6662(a) accuracy-related penalties of $255,429 and $8,590, respectively. Thermal petitioned the Tax Court, arguing that NVT retained equitable ownership of the leasehold addition and that the IRS's adjustments and penalties were erroneous.

The Court’s Analysis of the Law and Application to the Facts

Determination of Gross Income and Ownership

The Tax Court first analyzed the fundamental question of whether the NVT funding constituted gross income under Section 61(a). Section 61(a) broadly defines gross income as "all income from whatever source derived," which the Supreme Court has interpreted to include all "accessions to wealth, clearly realized, and over which the taxpayers have complete dominion" (Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955)).

To ascertain if Thermal had dominion over the addition, the court evaluated the indicia of ownership for tax purposes based on Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221 (1981). Although Thermal argued that NVT held an equitable interest in the addition, the court noted "there is direct evidence showing Thermal’s ownership: Thermal paid the insurance and the taxes for the entire building, including the addition; Thermal bore the risks relating to the leasehold addition while Thermal possessed it; and the certificate of occupancy is in Thermal’s name". Because Thermal owned the addition and could not realistically be prevented from keeping the improvements, the court ruled the $4.3 million constituted an accession to wealth over which Thermal maintained complete dominion.

Section 118 and the CB&Q Test

The court next addressed Thermal's assertion that the funds were excludable under Section 118(a) as a contribution to capital. The analysis focused on the transferor's intent and the CB&Q five-part test. While the court agreed the funds became a "permanent part of Thermal’s working capital structure," it strictly evaluated whether the transfer was linked to compensation.

Citing Treas. Reg. § 1.118-1, the court noted that "money or property transferred to the corporation in consideration for goods or services rendered" cannot be excluded from gross income. The facts demonstrated that NVT's objective in funding the expansion was to obtain a higher volume of foil heaters at an economical price. The court highlighted that NVT captioned its purchase order as a "Pre-payment for heater capacity 2018". Due to this, the court ruled "the funds were clearly to be compensation for a service—future production volume at a higher output and a lower price per unit," and therefore, NVT lacked the requisite intent to make a tax-free capital contribution.

Statutory Exceptions Under Section 118(b)

The court went further, declaring that even if NVT had intended to make a non-shareholder capital contribution, the statutory exceptions under Section 118(b) foreclosed the application of Section 118(a). Section 118(b)(1) explicitly excepts from capital contribution treatment any amounts provided "in aid of construction" or transfers made by "a customer or potential customer". The court ruled that "the $4.3 million NVT provided was both 'in aid of construction' and made by a 'customer or potential customer' of Thermal," strictly requiring their inclusion in gross income.

Year of Inclusion for Accrual Taxpayers

Having determined the funds were taxable income, the court addressed timing. Under Treas. Reg. § 1.451-1(a), for an accrual-method taxpayer, "income is includible in gross income when all the events have occurred which fix the right to receive such income and the amount thereof can be determined with reasonable accuracy". Specifically, income fixes upon the earliest of payment received, payment due, or performance (Johnson v. Commissioner, 108 T.C. 448 (1997)). Because NVT transferred $4.085 million in 2017, the court concluded "the accrual method requires Thermal to include the $4.085 million received in 2017 on its 2017 tax return". Because the remaining $204,529 was not due, earned by performance, or paid until 2018, it was includible in the 2018 tax year.

Accuracy-Related Penalties and Reasonable Cause

Finally, the court evaluated the Commissioner's imposition of a 20% accuracy-related penalty under Section 6662(a) for the 2017 tax year. Section 6664(c)(1) provides relief if the taxpayer demonstrates reasonable cause and good faith.

The court evaluated Thermal's reliance on draft and finalized agreements with NVT. A draft Framework Agreement indicated that "Ownership of, and title to, [NVT] Property... shall remain vested in [NVT]" and included "facilities" within that definition. Furthermore, a finalized Supply Heads of Terms Agreement stated that "Title (ownership) [in the Dedicated Equipment (including premises)] shall remain vested in NVT". Based on this contractual language, Thermal’s consistent restriction of the facility to NVT's use, and Thermal's decision to forgo claiming depreciation on the addition, the judge ruled that this pattern "evinces an honest, though mistaken, belief that NVT owned the leasehold addition".

Conclusions

The Tax Court concluded that the $4.3 million NVT paid for the leasehold expansion represented taxable compensation rather than a tax-free contribution to capital, strictly requiring Thermal to include the total amounts in its gross income for the 2017 and 2018 tax years, respectively. However, the court provided partial relief to the taxpayer, concluding that Thermal successfully established a reasonable cause defense, thereby avoiding the 20% accuracy-related penalties for 2017.

Prepared with assistance from NotebookLM.