Definitive Guidance on the Federal Tax Treatment of the Sale of State Tax Credits
Let’s say you own a business that generates state tax credits for anything from making films to cleaning up highways to developing low-income housing in the long-neglected“Little Chechnya” section of downtown.
Sometimes, those credits provide an immediate benefit, allowing you to offset your state tax liability on a dollar-for-dollar basis. Other times, however, the credit may go unused due to the absence of a tax liability. During lean years, a taxpayer may find there is a greater benefit toselling the underlying credits — assuming the state permits it — in exchange for cash that can be used to fund operations.
The federal tax treatment — to both the seller and buyer of state tax credits — has long been somewhat unsettled. Any uncertainly should now be put to rest, however, as in 2011 the Tax Court and the IRS have solidified their positions on these issues.
Tax Treatment of Seller:
Character
Both the Tax Court [1] and the IRS [2] have held that the sale of a state tax credit generates capital gain to the seller:
If and when a transferable tax credit is transferred to another taxpayer for value, the original recipient must recognize the gain because the transaction is a sale for purposes of § 1001.
…a nonrefundable state tax credit that does not fall within the statutory exclusions in § 1221(a) is a capital asset for purposes of § 1221. [3]
Basis
In computing the capital gain resulting from the sale, the seller receives no offset for any basis in the underlying credit:
The original recipient did not purchase the tax credit. It was the state’s unilateral decision to grant the tax credit as a consequence of the original recipient’s compliance with one of the state statutes. Accordingly, the original recipient generally has no tax cost basis in the tax credit. [4]
Holding Period
While the characterization of capital gain is sure to encourage taxpayers, the news isn’t all good. The sale of a tax credit will generally result in short-term capital gain, as the holding period does not begin until the credit is generated:
The court found that taxpayers’ holding period in their credits began at the time the credits were granted and ended when petitioners sold them. Because the credits were sold in the same month they were received, the court held the capital gains from their sale were short term. [5]
Treatment to Buyer:
Less obvious, however, is the treatment of the buying taxpayer. The IRS held that the buying taxpayer must recognize income to the extent the amount of tax offset by the credit exceeds the taxpayer’s basis in the credit (the purchase price). For example, if the taxpayer pays $50 for a $100 tax credit in 2009 and uses the $100 credit to offset its 2009 tax liability in March of 2010, the taxpayer must recognize $50 of income for federal tax purposes in 2010.
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 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.
