In a coordinated issue paper dated April 8, 2008, the Large and Mid-Size Business Division (LMSB) of the Internal Revenue Service considered the question of whether bioenergy program payments received from the USDA are taxable. Specifically, the LMSB focused on whether these payments are excludable from income as nonshareholder contributions to capital under Section 118(a) of the Internal Revenue Code. Some taxpayers have relied on Section 118(a) to exclude bioenergy program payments from income. Based on its analysis of the relevant case law, the LMSB concluded that these payments do not qualify as nonshareholder contributions to capital under Section 118(a), and are therefore taxable.

The question of payments qualifying as nonshareholder contributions to capital is a high-priority audit issue for the IRS. The LMSB has classified "Section 118 abuse" as a Tier I audit issue, meaning that it is an issue of high strategic importance in several industries and that the IRS intends to coordinate resolution at the national level. In the past year, the LMSB has issued three industry directives to its directors and field examiners on issues relating to nonshareholder contributions to capital under Section 118. Two of the directives instructed field examiners to challenge all arguments raised by taxpayers operating in a noncorporate form (such as partnerships and limited liability companies) taking the position that Section 118 or some other theory permits payments to be excluded from income as nonshareholder contributions to capital. According to the IRS, the Section 118 exclusion is available only to corporations.

The LMSB's issue paper is intended to provide guidance to IRS field examiners. While not an official pronouncement such as a tax regulation or a ruling, an issue paper sets forth the IRS's current interpretation of a particular issue. Based on this paper and the earlier industry directives on Section 118, it appears that the IRS is prepared to challenge all bioenergy producers on the exclusion of bioenergy program payments from income.

The paper seems to be an advocacy memorandum summarizing the LMSB's position that bioenergy program payments do not qualify for exclusion as nonshareholder contributions to capital under Section 118(a). It concludes, without analysis, that the USDA's intent and motivation in making payments is to "supplement the operating income of bioenergy producers for the increased purchase and use of agricultural commodities to expand bioenergy production." While part of the statement appears to be taken from the stated objective of the bioenergy program to encourage producers of bioenergy by increasing purchases of certain eligible commodities, the paper does not explain why it concludes that bioenergy program payments are made to "supplement the operating income" of bioenergy producers. Moreover, it does not address the other stated objective of the bioenergy program: to "support new production capacity" for bioenergy. Supporting new capacity suggests an intent to encourage capital investment, a motive consistent with the nonshareholder capital-contribution theory.

In concluding that bioenergy program payments are taxable, the LMSB's paper focuses on the fact that the payments do not compensate or reimburse the participant for actual capital acquisitions. Rather, because payments are intended to supplement operating income, they are similar to subsidies paid to limit production-payments that tax regulations specifically treat as taxable income, not contributions to capital. Moreover, according to the IRS, a statutory purpose to promote public welfare is not enough to qualify for contribution to capital treatment if the payment is a reimbursement for deficiencies in operating income. The IRS observes that the payments are reported on IRS Form 1099-G, which also indicates that bioenergy program payments should be treated as taxable.

Based on the coordinated issue paper, it appears that the IRS is prepared to challenge all bioenergy producers on the exclusion of bioenergy program payments from income as contributions to capital. Recipients of payments who have excluded these payments from income should consult with their tax advisors about possible implications.

Mark Salsbury is a partner in Lindquist & Vennum's tax and business-planning practice group. Reach him at msalsbury@lindquist.com or (612) 371-3959.