Your application to receive a state or municipal economic development grant for your real-estate development project has been approved. That’s good news! The bad news is that the grant might be taxable income, thanks to the 2017 Tax Cuts and Jobs Act (the “Act”).
Change in the Law
Prior to the Act, the law provided that economic development grants received by partnerships and LLCs were taxable for federal income-tax purposes, but grants received by corporations or REITs (which are generally treated as corporations) were not. This disparate treatment was more of a historical accident than a policy-driven decision. Because tax-return preparers were often unaware of this disparate treatment, it is likely that many economic development grants received by partnerships and LLCs in the past were not reported as taxable income.
The Act amended Section 118 of the Internal Revenue Code to provide that “any contribution by any governmental entity or civic group (other than a contribution made by a shareholder as such)” is included in the grantee’s gross income for federal income-tax purposes. Consequently, economic development grants received by all entities including corporations are now taxable income. This amendment generally applies to grants made after December 22, 2017, the date of enactment of the Act.
Grants as Taxable Income
If you receive an economic development grant that is taxable under amended Section 118, the sources and uses of funds for your project will have to account for this additional tax burden. This may be no small challenge.
For example, assume that a Pennsylvania project with a total projected cost of $45M is expected to be funded by $10M of equity contributions, a $30M mortgage loan, and a $5M Pennsylvania Redevelopment Assistance Capital Program grant, and that the grant money will be disbursed when the project is completed. Part of the taxable income generated by the grant may offset by depreciation deductions, but most of the grant will presumably increase the taxable income of the developer-grantee in the year the grant is received. If the developer-grantee is an LLC (taxed as a partnership), and if the LLC’s members are individual PA residents in the top federal income-tax bracket (37%), their additional income tax liability resulting from the grant is approximately $2M.
How will this additional tax liability be paid? The LLC members will presumably expect the developer-grantee to fund this tax liability, so that the members will not have to pay out of pocket. Grant recipients should consult their legal advisors to plan for this additional tax liability.
Alternative Forms of Governmental Support
To avoid this additional tax liability, developers instead of applying for economic development grants, could appeal to the states and municipalities for non-taxable assistance to development projects. For example, states and municipalities may be able to deliver incentives comparable to development grants through state or local tax credits or other tax reduction mechanisms, or by paying for neighboring street, utility, or other public improvements which would benefit the project by reducing or eliminating these costs to the developer. These incentives would assist the development project but would not be taxable to the developer.
Despite amended Section 118, not all economic development grants will be taxable. The Act includes a grandfather clause which states that grants to corporations are not taxable if such grants are part of a “master development plan” that was approved by a governmental entity before December 22, 2017. The approving governmental entity does not necessarily have to be the same governmental entity making the grant. Neither the IRC nor the Treasury Regulations shed any light on what constitutes a “master development plan.” Grant recipients should have their legal advisors review their grant application history to see if a case can be made for the grant to be grandfathered.
Keep in mind that even if the grant is grandfathered, it will be taxable unless the grantee is a corporation. Partnerships and LLCs expecting grandfathered grants need to consult their legal advisors regarding their structure to keep these grants from becoming taxable.