Taxation of Grants and the Contribution to Capital Exception

As an early stage startup, companies are generally scrambling for funding and looking in any number of places to secure it. One key source of funding that is often overlooked is a grant. While grants come in various shapes and sizes, one of the most attractive aspects of many grants is that the granted funds need not be repaid, and the grantor does not acquire an equity stake in the startup. This allows an early stage startup to acquire funding for its business while not diluting the founders’ ownership stake. Grants come in all shapes and sizes, including public grants from state or federal government. While grants are often optimal sources of funding, most grants are still taxable income.

Section 61 of the Internal Revenue Code (“IRC”) defines gross income to mean “all income from whatever source derived.” As a result, generally speaking, grants are considered gross income and, like most gross income, grant money is taxable. This includes both government and private grants.

However, under certain circumstances, grants from government entities may be exempt from taxation. The most notable, and relevant exception is called the Contribution-to-Capital (“CtC”) exception. According to §118(a) of the IRC, a business need not include shareholder contributions to capital as gross income for tax purposes. Furthermore, under certain circumstances, contributions to capital from non-shareholders also qualify for the CtC exception. According to United States v. Chicago, Burlington & Quincy Railroad, 412 U.S. 401 (1973), in order to qualify for the CtC exception, the grant must have five characteristics: (1) the contribution must become a permanent part of the transferee’s working capital structure, (2) the grant money cannot be compensation for goods or services, (3) the contribution must be bargained for, (4) The contribution must foreseeably benefit the transferee in an amount commensurate with its value, and (5) the contribution must ordinarily be employed to generate additional income. In the case of a non-shareholder contribution to capital, the contribution must come from some governmental unit or civic group.

While § 118(a) sounds simple enough, it remains a source of considerable controversy and bares special consideration. First, and most obviously, the CtC exception only applies to corporate taxpayers, meaning LLCs are not eligible for the CtC exception. However, because the process of converting from an LLC to a C-Corp is generally quick and straightforward, an LLC may choose to convert to a C-Corp if it believes that the company has a relatively high probability of obtaining a CtC grant. Startups should balance the costs, both direct and indirect, of the conversion process with the potential money to be retained as a result of the CtC exception. For startups receiving only minimal grant money, the additional formality and structure of a corporation may not justify the small retention of money created through the CtC exception.

Next, the exception only applies when grant money is invested in real, depreciable capital. Therefore, startups that do not plan on using the windfalls of grant money on depreciable capital cannot avail themselves of the CtC exception. For example, many startups in the tech space often need to invest a great deal in hiring labor. However, using grant money to pay the salary of an employee or independent contractor would not be considered a contribution to capital and is therefore not eligible for the CtC exception.

Finally, startups should not make uninformed assumptions regarding whether the CtC exception applies to grant money received. The CtC exception is very narrow and the IRS has taken a decidedly stringent stance when deciding if the CtC exception applies, designating non-shareholder contributions to capital a Tier 1 examination issue. Startups should consult a tax-attorney or accountant when considering use of the CtC exception.