What Is Section 110 of the Internal Revenue Code?

Section 110 of the Internal Revenue Code (IRC) provides tax benefits to businesses that receive qualified incentives from government entities, such as cash grants or property transfers, to promote economic development. Understanding these provisions is crucial for companies seeking tax exclusions, as noncompliance can lead to unexpected liabilities.

Scope and Requirements

To qualify, a business must receive incentives from a government entity under a binding agreement. These incentives must be structured as non-shareholder contributions to capital, meaning they cannot be exchanged for goods, services, or equity. The law supports businesses expanding operations, constructing new facilities, or making investments aligned with public economic goals.

The incentives must be granted before the business makes the investment, ensuring they drive growth rather than reward past actions. Funds must be used for specific purposes, such as acquiring tangible property or funding infrastructure improvements. General operating expenses do not qualify.

State and local governments often provide incentives as cash grants, land transfers, or infrastructure support. For example, a city might offer a $5 million grant to a manufacturing company to build a facility, expecting job creation and economic benefits. Agreements must clearly define terms, including intended use and performance requirements, such as job creation or investment thresholds.

Exclusion of Certain Items

Not all government assistance qualifies under Section 110. Loans, even with favorable terms, do not meet the criteria. Zero-interest or forgivable loans are generally taxable unless covered by other tax provisions.

Tax abatements or credits also do not qualify. While they reduce a company’s tax liability, they are not direct contributions to capital. For example, a property tax exemption for relocating a business falls under different tax rules, such as Section 118.

Reimbursements for past expenses or losses are taxable. If a company receives funds to offset prior costs—such as environmental remediation or operational expenses—these amounts are considered income. The IRS scrutinizes such transactions to prevent reclassification of taxable income as capital contributions.

Documentation Obligations

Proper documentation is essential to substantiate the tax treatment of government incentives. Businesses must retain a formal agreement explicitly stating the contribution’s nature to ensure it qualifies as a non-shareholder capital contribution. This agreement should detail terms, including investment commitments or job creation targets. Without clear documentation, the IRS may reclassify the incentive as taxable income.

Businesses must also document how funds or property were used. Financial records, such as invoices, bank statements, and asset purchase agreements, should confirm the incentive was applied to eligible expenditures. If land or infrastructure improvements are involved, property appraisals and valuation reports help establish fair market value for accurate reporting.

Auditors may request additional records, including board meeting minutes or internal memos that provide context for the incentive. Correspondence with government agencies, such as approval letters or compliance reports, strengthens a company’s position if the exclusion is challenged. Businesses should retain these records for at least three years, though longer retention may be advisable for multi-year obligations.

Filing Process

Businesses must classify government incentives correctly in their tax filings. The exclusion applies at the entity level, meaning corporations, partnerships, and LLCs must reflect the incentive’s treatment in financial statements and tax returns. Corporations filing Form 1120 should exclude qualifying incentives from gross income. Partnerships and LLCs filing Form 1065 must ensure tax benefits are allocated appropriately.

Accounting treatment also matters. Under Generally Accepted Accounting Principles (GAAP), non-shareholder capital contributions should be recorded as additional paid-in capital rather than income. Businesses should reconcile book-tax differences on Schedule M-1 or M-3. If property is involved, depreciation schedules under MACRS must accurately reflect the asset’s basis to prevent IRS scrutiny.

Penalties for Noncompliance

Incorrectly excluding an incentive from taxable income can lead to financial and legal consequences. If the IRS determines a misclassification, the amount may be reclassified as taxable income, resulting in additional tax liabilities, interest, and penalties.

Under IRC Section 6662, accuracy-related penalties can be 20% of the underpaid tax if the misclassification leads to a substantial understatement of income. If the misreporting is deemed fraudulent, penalties under Section 6663 can reach 75% of the underpayment. Willful tax evasion can result in criminal charges, fines, and imprisonment. Businesses facing IRS audits may undergo further scrutiny, increasing the risk of additional adjustments and penalties.