On March 2, 2011, the IRS released Appeals Settlement Guidelines (ASG) addressing the federal income tax treatment of state and local economic development tax credits and incentives, other than refundable or transferrable credits or incentives.

Many taxpayers have long taken the position that state and local tax credits and incentives (e.g., tax rate reductions, tax credits for job creation or investment, and tax abatements or exemptions) should be treated as a payment to the taxpayer by the state or local government equal to the amount of the credit or incentive, followed by a payment of the tax by the taxpayer in the same amount. Under this approach, the payment to the taxpayer is included in gross income under Section 61 and deductible as a payment of tax under Section 164, but then excluded from income as a non-shareholder contribution to capital under Section 118. As a result, taxpayers claim an expense for the amount of the credit or incentive in exchange for a reduction in the basis of property under Section 362(c). The net effect is a deduction in the current tax year which is not recaptured until the taxpayer disposes of the reduced-basis property or depreciates the property. Often the property subject to basis reduction is non-depreciable real property, which effectively allows a near-permanent deferral of income.

The IRS identified this position as a Tier 1 issue and previously addressed it in Coordinated Issue Paper (CIP) LMSB-04-0408-023 (May 23, 2008). The ASG continues the guidance provided in the CIP and details the IRS position that non-refundable state and local credits and incentives are most appropriately characterized as reductions in liability that do not constitute income under Section 61 and do not give rise to additional deductions under Section 164. The IRS also takes the position that even if the incentives were income, they are not excludable non-shareholder contributions to capital under Section 118.