Taxability of Rebates: Federal Tax Issues
When a water utility makes rebate payments to a private property owner -- either residential or business -- to cover part or all of the cost of onsite, localized infrastructure (LI), for example, turf replacement, permeable pavers, or rain gardens, the principal federal income tax issue is whether these payments are taxable to the property owner under federal tax law.
Why does this matter?
Of course, by making the program less attractive to property owners, a tax on the reimbursement payment will make it less likely that a property owner will enroll in an LI rebate program. Thus, the burden on the property owner will lead to a less successful rebate program for the water utility.
In practice, this has been an ongoing challenge for water utilities.
What should a water utility do?
Until federal law is clarified on this issue, a water utility has two courses of action:
Arguments for Non-taxability
There are two basic arguments to support the conclusion that the rebate payments should not be taxable:
First, it may be argued that the LI rebate should not be treated as a taxable “accession to wealth” of the property owner. The purpose of the LI rebate is to enable the water utility to achieve water conservation or stormwater management objectives at least cost. The payment is being made to the property owner not to confer a benefit on the property owner, but rather because it may be cheaper for the water utility to have the property owner install the LI project than to build more water production capability or stormwater disposition facilities. Any benefit to the property owner may be incidental and may be offset by the property owner’s obligation, if any, to maintain the LI project.
Second, it may be argued that the payments should be treated for federal income tax purposes as a reduction of the purchase price of the LI rather than as taxable income. For example, when a retail customer purchases an automobile and receives a manufacturers rebate for a portion of the purchase price, the rebate is treated as a reduction of the automobile purchase price (and not as income to the purchaser). By analogy, it may be argued that the LI rebate payment by the water utility to the property owner should be treated as a reduction in the purchase price of the LI and therefore not as taxable income.
The strength of these arguments may vary depending on the particular facts surrounding each LI project.
Alternative Program Structures
There may be alternative ways to structure an LI rebate program for private property owners that would enhance the likelihood that the rebate payments would not be taxable to the property owner. We explore four such options below:
Under this structure, the property owner would grant an easement to the water utility to install the LI project. An easement is an actual property interest under local real property law. The easement is recorded as affecting legal title to the property and it binds not just the current property owner but also anyone to whom the property owner transfers the property in the future. Under the easement, the water utility would be granted the right to install the LI project and would actually own the project. The structure may be viewed as an analogous to a utility pole easement. If a property owner gives an easement to a utility to install a utility pole, the utility, not the property owner, is the owner of the utility pole. Similarly, it may be argued that, in this structure, the LI project is owned by the water utility, not by the property owner. Therefore, it may be argued that the payments to install the LI project should not be taxable to the property owner.
This approach results in the water utility’s having a property interest that appears on the property owner’s title to the property. This consequence would have to be carefully considered both by the water utility and by the property owner. Also, the LI project must be appropriate for an easement. For example, a rain garden to facilitate stormwater absorption might be appropriate for an easement while a low-flush toilet would not. However, we provide this structure for consideration, where appropriate, as a way of potentially avoiding taxability of the rebate payments to the property owner.
Ratepayers generally pay fees to their water utilities for the water they use. In addition, some jurisdictions impose stormwater fees requiring property owners to pay for (or at least help to alleviate) the costs they impose for failing to absorb the stormwater falling on their property. Rather than making rebate payments to property owners that install LI projects, water utilities could structure a program that allows a property owner a credit against the property owner’s water fees or stormwater fees for all or part of the amounts expended by the property owner for LI projects.
The IRS has issued a Revenue Ruling (a form of administrative guidance) holding that, where a customer of an electric utility receives a rate reduction or non-refundable credit on the customer’s electric bill for participating in an energy conservation program, the amount of the rate reduction or non-refundable credit is not taxable to the customer. (See Revenue Ruling 91-36, 1991-2 CB 17.) By analogy, it may be argued that if a property owner receives a rate reduction or non-refundable credit against the customer’s water bill or stormwater bill to defray part or all of the customer’s cost of installing a LI project, the rate reduction or non-refundable credit should not be taxable to the property owner.
The attractiveness of this structure will depend on a number of factors. One obvious factor (for stormwater LI) is whether the relevant jurisdiction imposes a broadly-applicable stormwater fee. Another factor is whether the water or stormwater bills are sufficiently substantial that the bill reduction or non-refundable credit will offset the portion of the property owner’s LI cost that would otherwise have been rebated by the water utility.
Another possible approach would be to structure the rebate payments as a credit against the property owner’s state tax liability. States often provide tax credits against state income taxes (or occasionally against other state taxes, such as real property taxes) for payments by state taxpayers that contribute to what the state considers to be worthy objectives. As one example, New York State provides a tax credit of up to $5,000 per year for 25% of the fair market value of food donations by farmers to food banks.
The way a state tax credit works is that it reduces the state tax liability dollar-for-dollar by the amount of the credit. For example, suppose the state tax rate is 10%, a taxpayer’s taxable income for state tax purposes is $20,000, and the tax credit is $300. Prior to application of the credit, the taxpayer’s state tax liability is 10% of $20,000, or $2,000. The tax credit reduces the tax by $300, from $2,000 to $1,700. A tax credit is much more valuable than a deduction because it reduces tax not taxable income. For example, if the $300 credit were instead a $300 deduction, it would reduce the taxpayer’s taxable income from $20,000 to $19,700 and would thus only reduce the taxpayer’s state tax liability from $2,000 to $1,970, a benefit of $30 as compared with the $300 benefit of a tax credit.
Generally, tax credits may be “non-refundable” or “refundable.” If the credit is non-refundable this means that if the taxpayer does not have sufficient tax liability to absorb the full amount of the credit, the unused portion is carried forward and can be used to offset tax liability in future years (sometimes subject to a limitation on the number of years it may be carried forward). If the tax credit is refundable, then, if the taxpayer does not have sufficient tax liability to absorb the full amount of the credit, the taxpayer may get a tax refund in the amount of the excess (in effect, a cash payment equal to the amount of the excess).
The reason to consider this structure is the federal tax treatment of the state tax credit. Generally, the IRS treats non-refundable credits as reductions in future state tax liability. Thus the reduction is not treated as current income to the taxpayer (although it may reduce the taxpayer’s deduction for state taxes, if any). In the case of a refundable credit, the IRS generally bifurcates the credit. The portion that reduces the taxpayer’s state tax liability is treated as a reduction in state tax paid (the same treatment as a non-refundable credit) and the portion that is actually paid to the taxpayer as a tax refund is treated as taxable.
Accordingly, a state could structure a LI project rebate program as a state tax credit. Under this structure, a state could provide a tax credit against state income tax for all or part of the payments made by a property owner for a LI project. If the tax credit were non-refundable, as described in the previous paragraph, the amount of the tax credit should not currently be taxable to the property owner. If the tax credit were refundable, then only the amount actually paid as a tax refund should be taxable to the property owner.
This structure could also be used with a tax credit against the property owner’s real property taxes rather than state income taxes, if this were preferable. This approach, whether used in conjunction with state income taxes or real property taxes, would require the state legislature to enact a statute to effectuate the program. There undoubtedly would be complexities that would have to be addressed as well. For example, water utilities should consider the recent Treasury regulations aimed at curbing efforts to avoid the limitation on deducting state and local taxes (see TD 9864, 6/11/19) and whether these regulations have any implications for the tax credit structure. Nevertheless, we offer this as another potential solution.
Separate from the discussion above, water rebate programs specifically directed to disadvantaged communities may qualify for another exception to taxability. Under the “general welfare exception,” government payments to the needy are not generally subject to federal income tax. To come within this exception, the IRS generally requires the payments to be (i) made from a governmental general welfare fund; (ii) for the promotion of the general welfare (that is, on the basis of need rather than to the general population); and (iii) not made as payment for services. The general welfare exception has generally been limited to those receiving government payments to help them with their individual needs (for example, housing, education, and basic sustenance). Payments to compensate for lost profits or business income do not qualify nor do payments made to the population generally without regard for need.
Based on these principles, a water utility could consider structuring a rebate or direct installation program tailored to the needs of low income residents. Payments under such a program may potentially be nontaxable to the recipients based on the general welfare exception. Of course, the applicability of the “general welfare exception" would depend on the particular features of the program, including the income limitations or other measures of need.
Written in cooperation with Roger Baneman, advisor, Natural Resources Defense Council
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The foregoing general discussion is not legal or tax advice. The actual tax consequences will depend on the particular facts of each program. Water utilities and property owners are urged to consult with their own tax advisors about the taxability of any rebate payment or any other federal, state, or local tax issues in connection therewith.
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