Judge Thomas Ambro of the U.S. Court of Appeals for the Third Circuit. Courtesy photo

The U.S. Court of Appeals for the Third Circuit has ruled that $56 million in cash grants that a company received from New Jersey's Economic Development Authority to relocate from New York are taxable income.

With state economic incentive programs for businesses already undergoing scrutiny in Trenton, the ruling imposing taxes on benefits is a further complication for lawyers advising participants in such programs.

The decision reverses a ruling by the U.S. Tax Court that deemed the grants to BrokerTec Holdings a contribution to capital, which placed them off-limits to taxing authorities. The Third Circuit said the money was taxable because the state did not restrict how BrokerTec could use those funds and because the grants were calculated based on the amount of income tax revenue the new jobs would generate.

The issue of whether state economic development grants are taxable appears to have been unsettled before the BrokerTec case was decided, said tax lawyer Robert Schwartz of Herold Law in Warren who was not involved in the BrokerTec case. BrokerTec's position that the grants were nontaxable was reasonable, given that the Tax Court upheld it, but apparently the Internal Revenue Service decided to take a stand declaring that income taxable, Schwartz said.

"The IRS must have said 'We don't like that.' Somebody had to raise the issue, or it's no issue," Schwartz said.

Barring an appeal to the U.S. Supreme Court by BrokerTec, the Third Circuit ruling could force other corporate recipients of such grants to revisit their past returns, according to Schwartz.

BrokerTec, a financial company, sought new space after its offices in the World Trade Center were destroyed in the 9/11 attacks. The company relocated its 750 brokers and other employees to Jersey City after it was unable to find suitable space in Midtown and its employees were reluctant to return to the area of the World Trade Center.

BrokerTec applied for and was awarded a grant under the state's Business Employment Incentive Program, which awards grants to companies undertaking a relocation or expansion that creates a net increase in employment in New Jersey, for projects that would be economically sound and beneficial to the state by increasing employment and strengthening the economy, and where grants are material to a company's decision to expand or relocate.

For its tax returns of 2010 to 2013, BrokerTec recorded $56 million in grant payments as nontaxable contributions to capital. The Internal Revenue Service, contending that the grants were taxable income, issued BrokerTec a deficiency notice.

The court's discussion in the case about whether a grant is considered a capital contribution raises an issue that had been frequently raised in earlier days when railroads and electric utility companies regularly received government grants to expand their services, Schwartz said.

In April 2019, Senior U.S. Tax Court Judge Julian Jacobs ruled in favor of BrokerTec after a bench trial. Jacobs concluded that the New Jersey program's purpose was to enlarge the working capital of BrokerTec and therefore was a contribution to capital, not taxable income. Jacobs found that the facts of the case were similar to a 1950 U.S. Supreme Court case, Brown Shoe v. Commissioner,  and a 1949 Third Circuit case, Commissioner v. McKay Products, both finding relocation incentives paid to local businesses exempt from taxation.

At the Third Circuit, the IRS cited a 1973 U.S. Supreme Court ruling in United States v. Chicago, Burlington & Quincy R.R., which said a nonshareholder contribution to capital must become a permanent part of the recipient's working capital structure. The IRS said BrokerTec grants failed the test—the grants could be used for any purpose.

At the Third Circuit, Judges Thomas Ambro, Patty Shwartz and Stephanos Bibas agreed with the application of Chicago, Burlington & Quincy, and went on to observe that "neither McKay Products nor Brown Shoe involved cash grants that were entirely unrestricted in use and calculated on the basis of wages paid rather than on the basis of the amount spent to relocate."

It is undisputed that New Jersey placed no restriction on use of the grants, and that the amount of the grants was not tied to the amount of capital improvements BrokerTec would make, Ambro wrote for the court. In light of those facts, BrokerTec cannot show that New Jersey intended the incentive payments to become a permanent part of the company's working capital structure, Ambro wrote.

A Department of Justice spokeswoman, Alison Kjergaard, said the agency would not comment on the ruling. The agency's Richard Zuckerman, Travis Greaves, Judith Hagley, Gilbert Rothenberg and Francesca Ugolini were on the case.

BrokerTec was represented by Theresa Abney, David Blair and Robert Willmore of Crowell & Moring in Washington, D.C.  Blair, who argued for BrokerTec, said the firm would not comment on the ruling.