David J. Maines & Tami L. Maines v. Commissioner

DAVID J. MAINES AND TAMI L. MAINES, PETITIONERS v.
COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
Docket No. 14699–12. Filed March 11, 2015.
Ps received targeted economic development payments from
the state of New York. New York calls these payments
‘‘credits’’ and treats them as refunds for ‘‘overpayments’’ of
state tax. All the credits required Ps to make some amount
of business expenditure or investment in targeted areas
within the state. One of the credits, the QEZE Real Property
Tax Credit, is limited to the amount of past real-property tax
actually paid. The other two credits, the EZ Investment
Credit and the EZ Wage Credit, are not limited to past tax
actually paid. All the credits first reduce a taxpayer’s state
income-tax liability; any excess credits may be carried forward
to future years or partially refunded. Held: The state-law
label of the credits as ‘‘overpayments’’ of past tax is not
controlling for Federal tax purposes. Because the EZ Invest-
ment Credit and the EZ Wage Credit do not depend on past
tax payments, they are not refunds of past ‘‘overpayments’’
but rather are like direct subsidies. Because it does depend on
past property-tax payments, the QEZE Real Property Tax
Credit is treated like a refund of past overpayments. Held,
further, the portions of the EZ Investment Credits and the EZ
Wage Credits that only reduce Ps’ state-tax liabilities are not
taxable accessions to wealth. However, any excess portions of
the credits that are refundable are taxable accessions to
wealth to Ps. Held, further, the portions of the QEZE Real
Property Tax Credit payments that only reduce Ps’ state-tax
liabilities are not taxable accessions to wealth. Refundable
portions of the QEZE Real Property Tax Credit payments are
includible in Ps’ gross income under the tax-benefit rule to the
extent that Ps actually benefited from previous deductions for
property-tax payments.
123
124 144 UNITED STATES TAX COURT REPORTS (123)
Ryan M. Mead, for petitioners.
John M. Janusz, Kevin Michael Murphy, Justin G. Meeks,
and Anne D. Melzer, for respondent.
OPINION
HOLMES, Judge: 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 refund-
able. David and Tami Maines say that none of the credits
should be taxable because New York labels them ‘‘overpay-
ments’’ of past state income tax, and they never claimed
prior deductions for state income tax. The Commissioner dis-
agrees and argues that these refundable credits are, in sub-
stance even if not in name, cash subsidies to private enter-
prise—and just another form of taxable income. 1
Background
The New York Economic Development Zones Act offers
state-tax incentives to attract new businesses and to encour-
age expansion of existing ones. N.Y. Gen. Mun. Law secs.
955–969 (McKinney 2012). 2 In 2000 the program changed its
name to the Empire Zones Program (EZ Program). The EZ
Program provides incentives to stimulate private investment
and business development, and tries to create jobs in impov-
erished areas in New York State. Businesses in Empire
1 The New York Constitution prohibits direct gifts to corporations or in-
dividuals from state funds. N.Y. Const. art. VII, sec. 8 (McKinney 2006).
Such clauses, found in many state constitutions, present perhaps inten-
tional difficulties for the sort of targeted economic development at issue in
this case. See Peter J. Galie & Christopher Bopst, ‘‘Anything Goes: A His-
tory of New York’s Gift and Loan Clauses’’, 75 Alb. L. Rev. 2005, 2005–
2006 (2012) (gift and loan restrictions strictly limit state and local govern-
ment taxing and spending powers); Martin E. Gold, ‘‘Economic Develop-
ment Projects: A Perspective’’, 19 Urb. Law. 193, 210 (1987) (constitutional
prohibitions major limitation on economic development). We decide in this
case only the possible federal-tax recharacterization of the refundable cred-
its at issue here, and not any possible state-law recharacterizations.
2 Section references that do not cite New York law are to the Internal
Revenue Code in effect for the years in issue. All references to Rules are
to the Tax Court Rules of Practice and Procedure.
(123) MAINES v. COMMISSIONER 125
Zones have to apply to become certified EZ businesses.
Certified EZ businesses qualify for certain EZ tax credits.
A certified EZ business that meets specific employment tests
may become a Qualified Empire Zone Enterprise (QEZE).
N.Y. Tax Law sec. 14(a) (McKinney 2014). QEZEs are eligible
for additional targeted tax credits. The various EZ credits
require that the business stay put within a designated area
and meet certain annual employment requirements. See, e.g.,
id. secs. 15(a) and (b), 16.
The three credits at issue in this case are the QEZE Credit
for Real Property Taxes, id. secs. 15, 606(bb), the EZ Invest-
ment Credit, id. sec. 606(j), and the EZ Wage Credit, id. sec.
606(k). Eligibility for all the credits depends on a business’
meeting the requirements. EZ businesses that are corporate-
level taxpayers, get credits against their franchise-tax
liability; EZ businesses that are passthrough entities, such as
partnerships, S corporations, or LLCs taxed as partnerships,
get credits against the personal income-tax liabilities of their
partners or members. The taxpayers in this case, the
Maineses, own two firms, Endicott Interconnect Tech-
nologies, Inc., and Huron Real Estate Associates. Endicott is
an S corporation, and Huron is an LLC taxed as a partner-
ship. 3 Therefore any reference to ‘‘taxpayer’’ refers to individ-
uals such as the Maineses and not to corporate taxpayers;
any reference to ‘‘shareholders’’ refers to shareholders in S
corporations.
Because eligibility for the credits depends on a business’
meeting specific requirements, the full credit amount is cal-
culated at the entity level even for pass-through entities. A
partnership, for example, would report the credit amount on
its NY Form IT–204, Partnership Return. It would then
3 Taxation of S corporations is under subchapter S of the Code, and tax-
ation of partnerships is under subchapter K. S corporations and partner-
ships are similar in that they do not pay taxes themselves but rather pass
through items of income and deduction to their shareholders or partners.
Secs. 701, 1366(a)(1). As an LLC (which stands for limited liability com-
pany) with two or more members, Huron had a choice of how it would be
taxed—the Code treats such an LLC as a partnership unless the LLC
elects otherwise. Sec. 301.7701–3(b)(1)(i), Proced. & Admin. Regs. Huron
did not elect otherwise. Even though they don’t pay taxes, however, both
S corporations and partnerships do file information returns to report their
income and deductions to their owners. See secs. 701, 6031, 6037.
126 144 UNITED STATES TAX COURT REPORTS (123)
report to individual partners (or, in the case of LLCs, mem-
bers; or, in the case of S corporations, shareholders) their
distributive share of the ‘‘pass-through credits’’ on Form IT–
204–IP, New York Partner’s Schedule K–1. An individual
claims his share of these credits on credit-specific forms, such
as Form IT–601, Claim for EZ Wage Tax Credit, or Form IT–
606, Claim for QEZE Credit for Real Property Taxes. He
then reports these amounts on his personal income-tax
return, New York Form IT–201, Resident Income Tax
Return, which results in credit amounts that reduce his indi-
vidual income-tax liability and any refundable portion being
paid by the state to him individually. The process is similar
for other passthrough entities, such as S corporations.
The first tax credit at issue here is the QEZE Real Prop-
erty Tax Credit. N.Y. Tax Law sec. 606(bb). The formula for
computing this credit starts with the amount of real-property
taxes a QEZE paid, and depends on when the business first
became a QEZE. Id. sec. 15(b)(1) and (2). The QEZE cal-
culates the total credit amount based on the property taxes
previously paid, and when the QEZE is a passthrough entity,
it provides its partners or shareholders with a distributive
share of the credit. Id. It was the taxes paid and the business
activity of Huron and Endicott that caused New York to pay
the credits, but New York does not distinguish between
forms of business when passing out QEZE credits: Partners
in a QEZE partnership or shareholders of a QEZE New York
S corporation receive distributive shares of the credit and
claim that amount on their individual returns. The amount,
however, cannot exceed the real-property taxes paid, which
in this case means the amount of real-property taxes that
Huron or Endicott paid. See id. subsecs. (e) and (f–1). 4 It is
4 The amount of credit and tax benefit that passes through to the
Maineses is a consequence of the property tax Huron pays. Huron’s prop-
erty taxes must be taken into account at the partnership level for its tax-
able year, and therefore its claimed property-tax expenses and the
Maineses’ share of those expenses are partnership items. See sec.
6231(a)(3); sec. 301.6231(a)(3)–1, Proced. & Admin. Regs. These credits—
because they pass through to the Maineses—affect the Maineses’ federal
tax bill. That makes them ‘‘affected items.’’ See sec. 6231(a)(5). The Com-
missioner may issue an affected-items notice of deficiency without opening
and closing a partnership-level proceeding as long as the Commissioner is
bound by the partnership items as reflected on the partnership’s return.
See, e.g., Meruelo v. Commissioner, 691 F.3d 1108, 1109, 1117 (9th Cir.
(123) MAINES v. COMMISSIONER 127
important to note that while the amount of the credit is
based upon the amount of real-property tax paid, the credit
is against the New York income-tax liability (or corporate-
franchise tax liability) of the taxpayer who claims the credit.
Id. subsec. (a). Any amount of an individual’s distributive
share of the credit not used in a particular tax year to reduce
an income-tax liability is treated as an overpayment of New
York income tax. Id. sec. 606(bb)(2). New York State does not
tax the refunded portion of the credit, but treats it as a
refund of state income tax. Id. So to summarize, as a QEZE,
Huron qualified for the credit based on the amount of prop-
erty tax it paid, but it was the Maineses who claimed their
distributive share of the property-tax credit on their indi-
vidual returns and who used it to reduce their own income-
tax liability and receive a refund.
The second credit at issue is the EZ Investment Credit.
This credit is eight percent of the cost or other basis for fed-
eral income-tax purposes of tangible property in an Empire
Zone and acquired or built while the area is designated as
an Empire Zone. N.Y. Tax Law sec. 606(j)(1). To be eligible,
the property must meet several requirements. It must be
‘‘purchased’’ as defined in section 179(d), located in a New
York State Empire Zone, depreciable under the Code with a
useful life of four or more years, and fit into one of only five
listed categories. N.Y. Tax Law sec. 606(j)(2) and (3). The
credit is against income tax or the corporate franchise tax,
and the taxpayer claiming the credit—in this case an indi-
vidual partner or shareholder in an S corporation—may
carry forward any unused portion of the credit or may
receive fifty percent of the excess as a refund if the taxpayer
qualified as an owner of a new business under N.Y. Tax Law
sec. 606(a)(10). See id. subsec. (j)(4).
The final credit at issue here is the EZ Wage Credit. Id.subsec. (k). An EZ business qualifies for the EZ Wage Credit
if its jobs, employees, and employment terms meet certain
requirements. As with the other two credits, the credit is
against a corporate taxpayer’s franchise tax or an individ-
ual’s income tax. A pass-through EZ business reports to its
partners or shareholders their distributive share of the EZ
2012), aff ’g 132 T.C. 355 (2009); Gustin v. Commissioner, T.C. Memo.
2002–64.
128 144 UNITED STATES TAX COURT REPORTS (123)
Wage Credit, and those individuals claim it as a credit
against the New York income tax on their personal returns.
Any excess credit that remains after reducing an individual’s
income-tax liability may be carried over or partially
refunded. Id. subsec. (k)(5).
The Maineses are partners in Huron and shareholders in
Endicott, and their businesses responded to the incentives
New York gave them. Huron qualified for the QEZE Real
Property Tax, the EZ Investment, and the EZ Wage Credits.
And Endicott Interconnect’s business likewise qualified it for
the EZ Investment and the EZ Wage Credits. From 2005 to
2007 Huron deducted local property-tax payments on its fed-
eral returns—specifically, on Form 8825, Rental Real Estate
Income and Expenses of a Partnership or an S Corporation—
reducing the amount of income reported to the Maineses on
their Schedules K–1, Partner’s Share of Income, Deductions,
Credits, etc.
On their New York income-tax returns, Forms IT–201, the
Maineses claimed no state withholding or estimated tax pay-
ments. But for 2005 they wiped out half their state income-
tax liability with nonrefundable state credits not at issue in
this case and the other half with part of the refundable EZ
credits; for 2006 and 2007, they wiped out their entire state
income-tax liability with nonrefundable state credits. Thus
for tax years 2005 to 2007, they had actually paid no state
income taxes.
But having done just what New York wanted, the
Maineses reaped a bountiful harvest of the New York EZ
credits for this period. And because they had little to no state
income-tax liability in these years for the credits to offset,
the refundable credits led to large ‘‘refund’’ payments from
New York to the Maineses.
Discussion
The parties disagree about none of these facts, and both
have moved for summary judgment. Their dispute is instead
about whether these excess refundable state-tax credits are
taxable income under federal law. It is a novel and purely
legal question. 5
5 This case is one of eleven related but unconsolidated cases filed by New
York residents arising from disputes about the federal tax treatment of
(123) MAINES v. COMMISSIONER 129
A. Tax Benefits, State-Created Legal Interests, and Federal
Characterization
We begin with an introduction to the ‘‘tax benefit rule.’’
The need for this rule lies in our system of taxing income on
an annual basis. The world doesn’t come to an end and then
begin again on January 1 every year, so courts early on had
to figure out what to do when a transaction looked one way
at the end of a tax year but looked different in a later year.
The classic example is a bad-debt deduction. Imagine a
taxpayer who writes off the principal of a loan in January
2000 because his debtor can’t pay. But then in September his
debtor wins the lottery and repays the debt. No bad-debt
deduction here, because the debt turned out not to be bad.
But what happens if we move the hypothetical forward six
months? The taxpayer writes off the loan in July 2000.
Nothing changes before the end of the year, so the taxpayer
is entitled to claim a bad-debt deduction. See sec. 166. But
the debtor wins the lottery in February 2001 and repays the
debt.
Remember that in this second hypothetical, the taxpayer
was getting a deduction for unrepaid principal. The return of
principal is generally not includible in taxable income. See,
e.g., Nat’l Bank of Commerce of Seattle v. Commissioner, 115
F.2d 875, 876 (9th Cir. 1940), aff ’g 40 B.T.A. 72 (1939). And
the taxpayer—from the perspective of the end of his tax
year—quite properly took a bad-debt deduction. But before
taxes isn’t he economically in the same position as the tax-
payer in the first hypothetical?
Of course he is. And the tax-benefit rule is how tax law
squares the hypotheticals to reach the same result—more or
less. 6 It tells us to look at the subsequent event (in these
hypotheticals, the unexpected repayment of a loan) and ask:
If that event had occurred within the same taxable year,
would it ‘‘have foreclosed the deduction?’’ See Hillsboro Nat’l
Bank v. Commissioner, 460 U.S. 370, 383–84 (1983). 7 If yes,
the subsequent event is taxable.
these credits.
6 Though maybe not exactly—a taxpayer may find himself in different
tax brackets in different years, for example.
7 The rule is thus one of those odd bits of tax law that began in common-
Continued
130 144 UNITED STATES TAX COURT REPORTS (123)
Easy enough in the bad-debt case—if the debtor in the
second hypothetical had won the lottery in 2000 just like the
debtor in the first hypothetical, the taxpayer would have
been repaid and not entitled to a bad-debt deduction.
Now let’s move on to state-tax refunds. As all federal tax-
payers who itemize their deductions learn, a state income-tax
refund has to be added to one’s federal taxable income in the
year it’s received if one took a deduction for state income-tax
payments for a preceding year. The logic is pretty straight-
forward. Imagine a taxpayer who pays $1,000 in state income
taxes in year 1. His state (acting with unimaginable speed)
sends him a $200 refund just before the stroke of midnight
on New Year’s Eve. His state income-tax deduction is $800.
Now imagine another taxpayer who pays $1,000, but who
gets his refund only in year 2. Under the tax-benefit rule, he
gets the $1,000 deduction on his year 1 tax return, but has
to include the $200 refund in his year 2 income. Roughly
equal cases get treated roughly equally.
But what if someone who doesn’t itemize in year 1 gets a
refund in year 2? The answer in that case is that he does not
have to include his state income-tax refund on his year 2
return, see Tempel v. Commissioner, 136 T.C. 341, 351 n.19
(2011) (stating that state-tax refunds are not income unless
the taxpayer claimed a deduction for them—for example, by
itemizing for the previous year), aff ’d sub nom. Esgar Corp.
v. Commissioner, 744 F.3d 649 (10th Cir. 2014): He got no
deduction in year 1 for the state income tax that he paid, so
he got no federal tax benefit. And without a federal tax ben-
efit, he doesn’t have to bear a federal tax burden on a refund
he receives in year 2. See, e.g., Clark v. Commissioner, 40
B.T.A. 333, 335 (1939) (holding that so long as ‘‘petitioner
law fashion in caselaw. In the early days of the income tax, it was unclear
if the rule was valid. But then our predecessor, the U.S. Board of Tax Ap-
peals, upheld the application of the rule in 1929, see Excelsior Printing Co.
v. Commissioner, 16 B.T.A. 886 (1929), and the Fifth Circuit commented
soon thereafter that the rule was a principle that ‘‘seems to be taken for
granted,’’ Putnam Nat’l Bank v. Commissioner, 50 F.2d 158, 158 (5th Cir.
1931), aff ’g 20 B.T.A. 45 (1930). The rule since then has become partially
codified, see sec. 111, and is now settled as a background principle. For a
history of the development of the tax-benefit rule, see generally Boris I.
Bittker & Stephen B. Kanner, ‘‘The Tax Benefit Rule’’, 26 UCLA L. Rev.
265 (1978), and Patricia D. White, ‘‘An Essay on the Conceptual Founda-
tions of the Tax Benefit Rule’’, 82 Mich. L. Rev. 486 (1983).
(123) MAINES v. COMMISSIONER 131
neither could nor did take a deduction in a prior year,’’ any
amount he receives the next year ‘‘is not then includable in
his gross income’’); Rev. Rul. 79–315, 1979–2 C.B. 27.
Now we can edge toward the real facts in this case. The
Maineses stipulated that they took no deduction on their fed-
eral income-tax returns for the years at issue for state
income tax paid in the preceding year. 8 They argue that
their credits under the EZ Program are just like excess state
income-tax withholding—they point out that the credits that
New York gave them are defined by state law to be ‘‘overpay-
ments’’ of state income tax. 9 They argue that they are like
our nonitemizing hypothetical taxpayer, which means that
they got a big state income-tax refund that they don’t have
to include in their federal taxable income.
We have to agree with the Maineses in part. They are cor-
rect that New York calls these payments ‘‘credits’’ and that
New York says these ‘‘credits’’ are ‘‘overpayments’’ of state
income tax. But in truth the Maineses didn’t pay this
amount in state income tax. 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
8 After claiming at first that they never deducted New York real-property
taxes on their federal income-tax returns, the Maineses admitted that this
was incorrect—they never deducted New York real-property taxes person-
ally, but Huron did on its federal return. One might think this would mean
the Maineses’ receipt of the QEZE Credit for Real Property Taxes would
trigger the tax-benefit rule. The Maineses argue, however, that because
the New York tax code labels the QEZE Credit for Real Property Taxes
credit as a credit against state income tax—and any refund of that credit
as a refund of state income tax—we should instead focus on their federal
deduction of state income tax. According to them, because the credit is
nominally a refund of state income tax, its receipt can’t trigger the tax-
benefit rule for them because they never claimed a deduction for payment
of New York state income tax on their federal returns.
9 N.Y. Tax Law sec. 606(j)(4) (McKinney 2014) (labeling the Empire Zone
Investment Credit refunds ‘‘overpayments’’); id. subsec. (bb)(2) (labeling
the QEZE Credit for Real Property Taxes refunds ‘‘overpayments’’); id.subsec. (k)(5) (labeling the Empire Zone Wage Credit refunds ‘‘overpay-
ments’’).
132 144 UNITED STATES TAX COURT REPORTS (123)
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.’ ’’ In Drye v. United States, 528 U.S.
49, 58 (1999) (citing Morgan v. Commissioner, 309 U.S. 78,
80 (1940)), the Court explained that we look first to state law
to ‘‘determine what rights the taxpayer has in the property
the Government seeks to reach, then to federal law to deter-
mine whether the taxpayer’s state-delineated rights qualify
as ‘property’ or ‘rights to property’ within the compass of the
federal tax lien legislation.’’ That is, state law creates legal
rights and interests; federal law designates how those rights
or interests will be taxed. See id.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 govern-
ment? 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 con-
clude 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 nec-
essarily controlling for federal tax purposes. See Morgan, 309
U.S. at 81; Patel v. Commissioner, 138 T.C. 395, 404 (2012).
Federal tax law looks instead to the substance (rather than
the form) of the legal interests and relationships established
by state law. See United States v. Irvine, 511 U.S. 224, 238–
40 (1994).
(123) MAINES v. COMMISSIONER 133
Our decision in Buffalo Wire Works Co. v. Commissioner,
74 T.C. 925, 936 (1980), aff ’d without published opinion, 659
F.2d 1058 (2d Cir. 1981), supports this. In Buffalo Wire
Works we had to determine the character of condemnation
payments made by the city of Buffalo to the taxpayer. Under
New York law, condemnation awards included compensation
for land, building, and fixtures—and a court had to deter-
mine the compensation for the value of fixtures by calcu-
lating the cost of moving them. Id. at 927–28. The IRS
argued that this meant that part of the condemnation award
was a reimbursement for moving expenses (taxable in the
case under the tax-benefit rule because the taxpayer had pre-
viously deducted the moving expenses) and not a payment
entitled to nonrecognition treatment as an amount that was
involuntarily converted into similar property. See sec. 1033
(any gain from a condemnation award is not recognized if the
money is reinvested in a similar property).
We had to figure out whether the condemnation award for
the taxpayer’s fixtures ‘‘should be treated for purposes of
Federal income taxation as reimbursement of moving
expenses or as money into which property has been con-
verted.’’ Buffalo Wire Works, 74 T.C. at 934. And we con-
cluded that, regardless of state-law labels, the economic
reality of the payments showed them to be the latter. Id. at
936–37. 10
We have to draw the same distinction here: The Maineses
have a legal interest in the giant credits that New York law
entitles them to. Those credits were paid to the Maineses,
and nothing we say undermines New York’s decision to make
them. But federal tax law has its own say in how to charac-
terize those payments under the Code. Under New York law,
to qualify for the EZ Investment Credit, a taxpayer must
own a business that places in service qualified property in a
10 Note that the rest of our opinion in Buffalo Wire Works dealt with the
tax-benefit rule. We held that because none of the money was actually
compensation for moving expenses, the taxpayer did not have a ‘‘recovery’’
of previously deducted moving expenses. Buffalo Wire Works, 74 T.C. at
939. This was before the Supreme Court later invalidated the ‘‘recovery’’
test for the tax-benefit rule and replaced it with the ‘‘fundamentally incon-
sistent’’ test. Hillsboro Nat’l Bank v. Commissioner, 460 U.S. 370, 383
(1983). Hillsboro does not affect our analysis in Buffalo Wire Works regard-
ing state-law labels for federal tax purposes.
134 144 UNITED STATES TAX COURT REPORTS (123)
designated Empire Zone. To qualify for the EZ Wage Credit,
a taxpayer must own a business that has full-time targeted
employees who receive qualified EZ wages. Neither credit is,
in substance, a refund of previously paid state taxes
deducted under federal law. They are just transfers from
New York to the taxpayer—subsidies essentially.
The QEZE Real Property Tax Credit is different. Tax-
payers receive a QEZE Real Property Tax Credit only if their
business qualifies as a QEZE and pays eligible real-property
taxes, and—this is important—the amount of this credit
cannot exceed the amount of those taxes actually paid. The
refundable portion of this credit is indeed a tax refund—it is
in substance a refund of previously paid property taxes even
if New York labels it a credit against state income taxes. And
this means that our analysis of the EZ Investment and Wage
Credits will be different from our analysis of the QEZE Real
Property Tax Credit.
B. The EZ Investment and Wage Credits
Section 61(a) defines gross income as ‘‘all income from
whatever source derived.’’ Payments that are ‘‘undeniable
accessions to wealth, clearly realized, and over which the tax-
payers have complete dominion’’ are taxable income unless
an exclusion applies. Commissioner v. Glenshaw Glass Co.,
348 U.S. 426, 431 (1955). Section 61 is meant to extend to
the full measure of Congress’s taxing power, and we have to
construe exclusions from income narrowly. Commissioner v.
Schleier, 515 U.S. 323, 327–28 (1995) (citing United States v.
Burke, 504 U.S. 229, 248 (1992) (Souter, J., concurring)).
Receipt of tax deductions or credits that just reduce the
amount of tax a taxpayer would otherwise owe is not itself
a taxable event, ‘‘for the investor has received no money or
other ‘income’ within the meaning of the Internal Revenue
Code.’’ Randall v. Loftsgaarden, 478 U.S. 647, 657 (1986).
But what happens when those deductions or credits lead to
a state income-tax refund greater than the taxes actually
paid? Both parties point us to Tempel, where we stated that
the amount of a state-tax credit that reduces a tax liability
is not an accession to wealth under section 61. Tempel, 136
T.C. at 351. Both parties agree with this. The parties dis-
agree on what Tempel says about refundable portions of
(123) MAINES v. COMMISSIONER 135
credits. Tempel involved the tax treatment of the sale of
transferable Colorado state-tax credits that the taxpayers
received for a donation of a qualified conservation easement.
Id. at 342–43. Colorado allowed conservation easement
recipients to use their credits to receive a limited refund up
to $50,000 provided that the state had exceeded certain Colo-
rado constitutional tax-collection limits. Id. at 343. We held
that the mere receipt of these credits was not an accession
to wealth, but that gain realized from selling them to a third
party was capital gain. Id. at 349–52.
The opportunity to receive $50,000 under certain cir-
cumstances made the credits potentially refundable, however,
and this creates confusion and disagreement between the
parties. The Maineses point to the potential refund and
argue that Tempel held that the receipt of potentially refund-
able credits was not income to the taxpayer. This is true, but
it misses the issue in this case. In the year in which the tax-
payers in Tempel received and sold their credits, Colorado
made it impossible for them to receive a refund. Id. at 349–
50 (stating there is no evidence ‘‘that petitioners sold credits
they could have otherwise used to receive a refund’’). We also
stated it was ‘‘apparent that the transferred State tax credits
never represented a right to receive income from the state,’’
while reiterating that credits are not an accession to wealth
‘‘as long as they are used to offset or reduce the donor’s own
State tax responsibility.’’ Id. at 351 n.17. Thus, far from sug-
gesting that refunded portions of credits aren’t income, we
noted that the credits in Tempel never led to cash refunds
and emphasized that it is only the reduction of tax liability
that is not income to the taxpayer.
The Maineses are right that their EZ Investment and
Wage Credits are distinct from the credits we discussed in
Tempel—the Maineses did not receive cash in hand from
selling them to a third party. But we don’t see much of a dif-
ference between the Maineses’ Investment and Wage Credits
and those Colorado credits that we held taxable in Tempel.
The key distinction—as we held in Tempel—is that a non-
taxable credit is one that must be used to ‘‘offset or reduce’’
the taxpayer’s tax liability. With refundable portions of tax
credits, taxpayers may receive cash payments in excess of
their tax liability.
136 144 UNITED STATES TAX COURT REPORTS (123)
We therefore hold that this excess portion that remains
after first reducing state-tax liability and that may be
refunded is an accession to the Maineses’ wealth, and must
be included in their federal gross income under section 61 for
the year in which they receive the payment or are entitled
to receive the payment unless an exclusion applies. See secs.
101–140. And there is no exclusion from federal income tax
simply because a payment comes from a state government.
See Commissioner v. Kowalski, 434 U.S. 77, 81–82 (1977)
(whether cash payments designated as meal allowances to
state police troopers are excludable under section 119); Taggi
v. United States, 35 F.3d 93, 95 (2d Cir. 1994) (taxpayer
‘‘claiming an exclusion from income bears the burden of
proving that his claim falls within an exclusionary provision
of the Code’’); Dobra v. Commissioner, 111 T.C. 339, 349 n.16
(1998) (holding taxpayers seeking an exclusion from income
must bring themselves ‘‘within the clear scope of the exclu-
sion’’). There is also no federal exclusion simply because an
amount takes the form of a tax refund for state purposes.
It is only the potentially refundable excess credits that
must be included in gross income; and under the doctrine of
constructive receipt, this is the case whether or not the
Maineses elect to receive the excess or carry it forward. The
regulations say that even if income is not actually reduced to
a taxpayer’s possession, it is constructively received by the
taxpayer if it is somehow made available to him so that he
could draw on it if he wanted. Sec. 1.451–2(a), Income Tax
Regs. We have formulated this concept by saying that ‘‘a tax-
payer recognizes income when the taxpayer has an unquali-
fied, vested right to receive immediate payment.’’ Martin v.
Commissioner, 96 T.C. 814, 823 (1991). Income is not
constructively received if the taxpayer’s right to control it is
subject to substantial limitations. Sec. 1.451–2(a), Income
Tax Regs. Here, there were excess tax credits left after the
Maineses reduced their liability; the Maineses had a clear
right to receive a percentage of this excess as a direct pay-
ment; and there were no limits on the Maineses’ ability to
receive these payments. We must therefore hold that the
Maineses have constructively received income equal to what
they could have received as a direct payment even if they in
fact chose not to do so.
(123) MAINES v. COMMISSIONER 137
The Maineses also argue that the excess portion of the
refundable state-tax credit is a return of capital and thus not
income. See S. Pac. Co. v. Lowe, 247 U.S. 330 (1918). The
return (or recovery)-of-capital doctrine makes nontaxable the
repayment of an initial outlay. (For example, someone who
buys stock for $1,000 and sells it for $2,000 pays tax only on
the $1,000 gain.) The Maineses cite various revenue rulings
and general counsel memoranda in support of their claim,
but none of them justifies income exclusion in the present
situation. See Rev. Rul. 78–194, 1978–1 C.B. 24; Rev. Rul.
70–86, 1970–1 C.B. 23; I.R.S. Gen. Couns. Mem. 38247 (Jan.
16, 1980) (citing I.R.S. Gen. Couns. Mem. 35731 (Mar. 14,
1974)). The revenue rulings and the general counsel memo-
randa analyze situations where states refunded property
taxes or rent payments that had not provided earlier tax
benefits. In other words, their facts were just like those of a
taxpayer who paid state taxes but didn’t itemize and there-
fore never benefited from the payments.
The general counsel memoranda frame these payments as
a ‘‘return of capital’’ rather than a tax refund because some
of the recipients were renters and therefore never directly
paid property tax; for them, the payments were a refund of
rent expenses. I.R.S. Gen. Couns. Mem. 35731. And because
rent payments are not deductible, the state refund was not
for a previously deducted item and there was no tax-benefit
issue. Thus, rather than standing for some escape from the
tax-benefit rule, the memoranda clarify that such payments
were tax-free returns of capital only because they restored a
prior expense that had provided no previous tax benefit. See
id.In this case, it’s unclear if the Maineses claim the credits
are a tax-free return of capital because they are a return of
property tax, a return of income tax, or some other return of
capital. Their argument fails regardless. The Maineses didn’t
pay any income tax to New York in 2005, 2006, and 2007.
Therefore the credits can’t be a ‘‘return’’ of state income tax.
They did pay property tax (through Huron), but they also
benefited by deducting those payments (through Huron). This
means the credits can’t be a tax-free return of capital. And
while the amount of the investment credits takes into
account the costs of acquiring and improving real estate
(which are undoubtedly ‘‘capital’’ expenses), the authorities
138 144 UNITED STATES TAX COURT REPORTS (123)
that the Maineses cite involve the return of previously non-
deducted property tax and rent payments, and do not suggest
that payments like those at issue in this case are also a tax-
free ‘‘return of capital.’’ This argument is, in any event, also
underdeveloped on a summary-judgment motion—neither
party presented any evidence, for instance, of whether the
Maineses already received some tax benefit (such as depre-
ciation deductions) for their capital outlays on real property.
The Maineses also contend that their credits are exclud-
able from their taxable income as welfare. The Commissioner
has long held that certain payments from social-benefit pro-
grams that promote the general welfare are not includible in
gross income. See Rev. Rul. 2005–46, 2005–2 C.B. 120 (cer-
tain payments promoting general welfare are excludable, but
disaster-relief payments to businesses are not excludable). To
qualify for the general-welfare exclusion, a payment must (1)
be made from government funds, (2) promote the general
welfare (generally based on need), and (3) not be compensa-
tion for services. Id. Grants from welfare programs that don’t
require recipients to show need have not qualified for the
general-welfare exclusion. See Bailey v. Commissioner, 88
T.C. 1293, 1300 (1987) (denying the exclusion for payments
from a facade grant program when the taxpayer only had to
show ownership and building code compliance to qualify).
Critics of programs like New York’s might call them ‘‘cor-
porate 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 Invest-
ment and Wage Credits that do not just reduce state-tax
liability but are actually refundable are taxable income.
C. The QEZE Real Property Tax Credit
The Maineses’ QEZE Real Property Tax Credit is different
because it was limited to the amount that Huron had actu-
ally paid in real-property taxes. As we’ve already discussed,
(123) MAINES v. COMMISSIONER 139
the tax-benefit rule and section 111 are what we use to
answer this question. Under that rule and that section, a
taxpayer is allowed to exclude a refund from his income if,
but only if, he never got the benefit of a corresponding deduc-
tion for an earlier year.
The parties agree that Huron paid property taxes in 2005–
07 and that it deducted these taxes on its federal returns.
See sec. 164(a)(2). On its Forms 8825 Huron deducted prop-
erty taxes from its gross receipts to arrive at its net real-
estate income. Huron then calculated the Maineses’ distribu-
tive share of its net real-estate income and reported it to the
Maineses on their Schedule K–1. The Maineses reported this
amount on their Form 1040 on the line for partnership
income. Because Huron had deducted its property tax to cal-
culate its net real-estate income, the amount of net real-
estate income passed through to the Maineses was smaller
than it would have been had property tax not been deducted.
This decreased amount of passthrough income led to a
smaller taxable income reported by the Maineses on their
individual return, and thus smaller tax liability. This
decreased tax liability is a benefit to the Maineses, and their
receiving a cash refund of these previously deducted taxes is
fundamentally inconsistent with the previous deduction—the
distributive share of the passthrough QEZE Real Property
Tax Credit that belonged to and was claimed by the
Maineses, even though it was Huron that paid the under-
lying property tax at the entity level. See supra note 3.
Because the cash refund is fundamentally inconsistent with
Huron’s previous deduction, the tax-benefit rule applies. This
means that any refundable portion of the QEZE Real Prop-
erty Tax Credit that remained after first reducing the
Maineses’ state income-tax liability is taxable as income. 11
The exclusionary aspect of the tax-benefit rule under section
111(a) does not apply here to the extent that the decreased
pass-through income from Huron reduced the Maineses’ fed-
eral tax liability.
It is of no consequence that it was Huron that paid and
deducted the property taxes while it is the Maineses who are
11 Recall that whether or not the Maineses choose to receive the refund-
able portion of the credit, they are in constructive receipt of it and there-
fore must include it in their gross income.
140 144 UNITED STATES TAX COURT REPORTS (123)
receiving the refundable credit. The Maineses needn’t have
been the ones that personally claimed the earlier deduction
if their tax-free receipt of the credit is fundamentally incon-
sistent with the earlier tax treatment. In Frederick v.
Commissioner, 101 T.C. 35, 36 (1993), we faced a similar
situation when a C corporation 12 deducted interest expenses
before changing to an S corporation and passing through
recovered interest expenses to its shareholders. Although the
corporation initially claimed the deduction, we held that the
tax-benefit rule required inclusion of the recovered expenses
by S corporation shareholders because tax-free recovery of
those expenses was fundamentally inconsistent with the pre-
vious deduction that lowered the corporation’s income. Id. at
42–43. In reaching this conclusion, we noted that section 111
is not limited to cases where the same person receives both
the deduction in the earlier year and the recovery in the
later year. Id. at 44 n.10.
An appropriate order will be issued.
f
12 Taxation of a C corporation is under subchapter C of the Code. C cor-
porations (which include most large corporations) do pay tax at the cor-
porate level, unlike S corporations.