Does Buying and Selling State Tax Credits Yield Federal Tax Consequences?
Kentucky and Ohio offer a number of taxpayer incentives, such as nonrefundable and refundable tax credits, as a part of their state economic development programs. Non-refundable tax credits can only offset a tax liability, whereas a refundable tax credit is refunded to the taxpayer if there is credit in excess of a tax liability.
Sometimes taxpayers find themselves in situations where they cannot use a state credit. In such situations, there is a secondary market where buyers are matched with sellers and tax credits are sold at a discount. However, before engaging in a transaction to buy or sell a state tax credit, taxpayers should consider whether or not a sale is a taxable event, to both parties. The IRS has issued Chief Council Advice on the buying and selling of state tax credits, CCA 201147024. The CCA is not law, but it is the official interpretation of the IRS’ lawyers on a particular revenue position. In CCA 201147024, the IRS has taken the following position on the buying and selling of state tax credits, as it relates to the federal tax return:
- The initial receipt of a state tax credit, which can only be applied to the recipient’s state tax liability, is not includable in federal gross income. However, the subsequent sale of a transferrable tax credit by the original recipient for cash or other property is treated as a taxable event. To the extent the original recipient has no tax basis in the credit sold, gain equal to the sales price is recognized. Generally, the original recipient will have no basis in the credit because the credit was not obtained through purchase but rather through compliance with state laws.
- In general, the gain generated by the sale of the tax credit is deemed to be a capital gain. § 1221 of the internal revenue code defines a capital asset as one held by the taxpayer, whether or not connected with the taxpayer’s trade or business unless the property qualifies under one of eight exemptions.
- The purchaser’s basis in the tax credit becomes the amount paid for the credit. Any transaction costs incurred in acquiring the tax credit are includible in the basis of the tax the credit, unless they qualify as de minimis costs.
- If the original recipient sells the tax credit at a discount, the purchaser must recognize a gain as the credit it used. For federal tax purposes, the use of the tax credit to satisfy the purchaser’s state tax liability is a transfer of property to the state in satisfaction of the liability, not a reduction in the liability. Accordingly, in the year or years the purchaser applies the tax credit to satisfy its state tax liability, the purchaser will realize gain or loss under § 1001 equal to the difference, if any, between the basis of the tax credit and the amount of liability satisfied by the application of the tax credit. For example: if the purchaser pays $100 for a Kentucky tax credit that has a “face value” of $120 in year 1 and uses half of the credit to satisfy its $40 state tax liability in year 2, the purchaser would allocate $30 of the $100 tax basis to the credit used, pursuant to Regs. Sec. 1.61-6(a), and recognize a gain in the amount of $10 in year 2. In addition, the purchaser would be deemed to have made a payment of state tax in the amount of $40 for purposes of Sec. 164(a).
If you have any questions as to how this may impact your or your company, reach out to us online by clicking here, or call 513-241-8313 to speak with a member of the Barnes Dennig tax team.