Free Money Isn’t Free (Except When It Is)
For many high growth technology companies, a state or federal grant is a blessing. It can help fund R&D, clinical trials, or otherwise provide the capital needed to expand. The casual observer could hardly be faulted for thinking that if, for example, the National Institutes of Health wanted to give a company a grant, that the IRS wouldn’t tax the grant. That would be absurd, right? After all, why would one hand of the government want to take back cash that the other hand just offered? The truth is complicated, and exasperating. Government grants are in fact taxable depending on how the money is used, and how the recipient chooses to do business (i.e., LLC vs. Corp).
Here’s how the tax rules work. The general IRS rule is that all income (regardless of the source) is taxable. However, there is a major exception to this general rule. In 1954, the federal income tax laws were amended so that corporations (including S-corporations) could receive government grants tax-free – if certain conditions are met. Some of the key conditions for a grant to be tax-free include the following:
- the government money can’t be compensation for goods or services;
- the government money must be invested in depreciable property (e.g., equipment) rather than spent on payroll;
- the government money must be used to generate income (i.e., invested in the business rather than paid as a dividend).
Notably, the 1954 law didn’t cover grants received by LLCs or partnerships. This omission isn’t believed to be because of a federal bias against LLCs and partnerships. Rather, in 1954, the concept of LLCs and limited partnerships had not yet been created, and Congress probably thought that nobody in their right mind would do business (other than a mom and pop store) using a general partnership. Back then, corporations were essentially the only game in town. So Congress could be excused back then for not including LLCs and partnerships in the scope of this rule.
In the half century since, Congress never got around to clarifying the tax treatment of grants made to LLCs or partnerships. In the absence of any guidance from the IRS, most tax advisers assumed that LLCs and partnerships could rely on ancient Supreme Court law from the 1930s saying that grants are always tax-free.
The IRS recently broke its self-imposed veil of silence on this issue, and issued a memo to its auditors arguing that grants made to LLCs and partnerships are taxable. Many tax advisers responded to the IRS memo with a collective “They can’t really mean that, right?” In fact, in the last few years, the IRS has followed with a flurry of additional memos essentially saying “Oh yes, we really meant it.” Not wanting to pick a fight with the IRS, most tax advisers have now done a 180-degree turn and are advising that grants to LLCs and partnerships are taxable.
For the company that is expecting a government grant, the new IRS position may play a major factor in choosing between organizing as an LLC or corporation. As noted above, S-corporations (even though taxed as a passthrough) get the same ability to receive grants tax-free as C-corporations. But before an LLC expecting a grant rushes to convert to a corporation, it would be wise to examine how the upcoming grant would be used. Keep in mind that grants used to pay payroll or to pay independent contractors are always taxable, regardless of whether the grantee is a corporation. And also keep in mind that LLCs and partnerships have other tax benefits. So organizing as a corporation isn’t always the solution. Of course, there is always the hope that Congress will change the law and treat LLCs and partnerships the same as corporations in this regard – but don’t hold your breath.