Yesterday the Tax Court ruled that refundable business incentive tax credits issued by New York generate taxable income. Judge Holmes made the decision entertaining. Well, except maybe for the taxpayer who lost.
Credits works differently from deductions. A $100 tax credit reduces your tax by $100, while a $100 deduction reduces the tax of a taxpayer in the 25% bracket by only $25. When a credit is “refundable,” if it exceeds the tax you would otherwise owe, the government sends you a check for the excess. The federal Earned Income Tax Credit is the most common example. Iowa has several such credits, including its EITC and its research credit for business.
New York also uses refundable credits. Judge Holmes sets the stage (all emphasis is mine):
New York State uses extremely targeted tax credits as an incentive for extremely targeted economic development in extremely targeted locations. Those who receive these credits may be extremely benefited — even if they do not owe any state income tax, New York calls the credits overpayments of income tax and makes them refundable. David and Tami Maines say that none of the credits should be taxable because New York labels them “overpayments” of past state income tax, and they never claimed prior deductions for state income tax. The Commissioner disagrees and argues that these refundable credits are, in substance even if not in name, cash subsidies to private enterprise — and just another form of taxable income.
The taxpayer said that because New York called the refundable amount of the credits “overpayments,” they were like withholding:
So the key question in this case becomes whether a federal court applying federal law has to go along with New York’s definition.
The Maineses understand the importance of this question, and they argue that if New York State tax law calls these payments “overpayments” we have no power to call them something different. They point to cases like Aquilino v. United States, 363 U.S. 509, 513 (1960) (quoting United States v. Bess, 357 U.S. 51, 55 (1958)), where the Supreme Court held that Federal tax law “‘creates no property rights but merely attaches consequences, federally defined, to rights created under state law.”‘
Judge Holmes is unconvinced (my emphasis):
The Commissioner does not challenge these cases. And he also agrees that New York law labels the credits as “income tax credits,” and excesses or surpluses as “overpayments” of state income tax for state-tax purposes. But is a state’s legal label for a state-created right binding on the federal government? Here begins the disagreement. The Maineses contend that New York’s tax-law label of these excess EZ Credits as overpayments is a legal interest that binds the Commissioner and us when we analyze their taxability under federal law. The Commissioner warns that if this were true, a state could undermine federal tax law simply by including certain descriptive language in its statute. To use Lincoln’s famous example, 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. See George W. Julian, “Lincoln and the Proclamation of Emancipation,” in Reminiscences of Abraham Lincoln by Distinguished Men of His Time (Allen Thorndike Rice, ed., Harper & Bros. Publishers 1909), 227, 242 (1885), available at https://archive.org/details/cu31924012928937.
We have to side with the Commissioner (and Lincoln) on this one: “Calling the tail a leg would not make it a leg.” Id. Our precedents establish that a particular label given to a legal relationship or transaction under state law is not necessarily controlling for federal tax purposes.
The taxpayer advanced a more novel argument:
The Maineses also contend that their credits are excludable from their taxable income as welfare. The Commissioner has long held that certain payments from social-benefit programs that promote the general welfare are not includible in gross income.
I’ve called such credits “Corporate welfare” at least once or twice myself. But calling a tail a leg, or corporate welfare, doesn’t make it welfare for tax exclusion purposes:
Critics of programs like New York’s might call them “corporate welfare.” But that’s just a metaphor — the credits that New York gave to the Maineses were not conditioned on their showing need, which means they do not qualify for exclusion from taxable income under the general-welfare exception. See also, e.g., Rev. Rul. 2005-46 (holding that state grants for expenses incurred by businesses that agree to operate in disaster areas are not excludable under the general-welfare exclusion).
We therefore hold that portions of the excess EZ Investment and Wage Credits that do not just reduce state-tax liability but are actually refundable are taxable income.
One interesting thing about the New York credits at issue is that they can either be refunded, at the cost of a loss of some of the credits, or carried forward in full at the taxpayers option. In a footnote, Judge Holmes says that while the taxpayer has the option of whether to claim the refund, there is no option on when it affects taxable income:
Recall that whether or not the Maineses choose to receive the refundable portion of the credit, they are in constructive receipt of it and therefore must include it in their gross income.
This is a full-dress “reported” Tax Court decision, which means it is meant to guide future litigation in this area. A footnote in the decision says there are 10 other related New York cases pending. It has obvious implications for the Iowa research credit and historical building credits, which are refundable. There are many other such refundable tax credits in other states. I never doubted that such credits were taxable “accessions to wealth,” and the Tax Court feels the same way.
Cite: Maines, 144 T.C. No. 8.
Sen. Roby Smith, a Republican, has introduced Senate File 277, which would phase out taxes on retirement income over five years, starting in fiscal year 2017. The measure is co-sponsored by 23 Republican senators. He said that during his re-election campaign last fall, one of the common complaints he heard from older Iowa voters was the need to pay taxes on retirement income.
Let me register my complaint about having to pay taxes on income while I’m working. Can I get an exemption?
This sort of carve-out is a classic example of how the tax law goes bad. High rates make people motivated to carve out breaks for themselves. It works especially well if those seeking the breaks are organized and have time to spare to press their case, like retired folks.
But giving tax breaks just by virtue of age or working status is the wrong way to go. If a retired person is poor, reduce his taxes to take his poverty into account (the tax law already does so in a number of ways). But if he is wealthy and retired, why should he get a better deal than a less-wealthy person who still trudges to work every day? In terms of wealth, the elderly are better off than the not-so-elderly, as a group.
It would be much better for the legislature to cut the rates for everyone, get rid of special carve outs for the politically influential, and help the poor, of whatever age, with a reasonable exemption for low-income taxpayers.
Jason Dinesen asks Why Do Unethical Clients Bother Working With Tax and Accounting Pros?:
I asked one of my peers about this and he said it’s because that type of person likes to feel important. They “have an accountant” and they can brag about it to their friends.
It’s an excellent question. My answer is that they feel they are buying excuses. If they get caught, they will immediately blame the accountant.
The evidence at trial established that through NADN, the defendants promoted and sold a product called Tax Break 2000. Tax Break 2000 purported to be an online shopping website. The defendants falsely and fraudulently told customers that buying the product would allow them to claim legitimate income tax credits and deductions under the Americans with Disabilities Act (ADA) by modifying the website each customer was provided to make it accessible to the disabled.
If the stupidity of the tax scheme were a factor in sentencing, they’d have faced a firing squad.
Cara Griffith, Will There Be an Increase in State Transfer Pricing Audits? (Tax Analysts Blog). “States have not, however, been particularly successful in challenging the arm’s-length pricing of intercompany transactions”
Stephen Entin, Tax Indexing Turns 30 (Tax Policy Blog)
William Gale, Rubio-Lee Hints at Tax Reform’s Troubling Direction (TaxVox).
TaxProf, The IRS Scandal, Day 672. The state continues its efforts to criminalize opposition.
Tax Analysts ($link), IRS Stops Providing Exemption Letters to Press. Given the stellar performance of the IRS Exempt Organizations division, what’s not to trust?
Adrienne Gonzalez wonders What Are the Accounting Profession’s Darkest Secrets? (Going Concern). Other than the ritual human sacrifice?