Funds Received to Boost Production Were Income, Not Contributions to Capital

(Parker Tax Publishing April 2026)

The Tax Court held that funds received by a manufacturer from a company looking to help the manufacturer increase its production capacity of items that company was selling was income to the manufacturer and not a nontaxable contribution to capital under Code Sec. 118 as the manufacturer argued. However, the court concluded that the manufacturer had reasonable cause for its position and acted in good faith and was thus not liable for the accuracy-related penalty assessed by the IRS. Thermal Circuits, Inc., v. Comm'r, T.C. Memo. 2026-29.

Background

Thermal Circuits, Inc. (Thermal) is a C corporation that uses the accrual method of accounting. Since 1961 Thermal has been designing, engineering, and manufacturing foil heating components. Its products are used in a wide variety of devices, including electronics, medical equipment, automobiles, and electronic tobacco devices. In 2013 British American Tobacco (BAT), through a wholly owned subsidiary, Nicoventures Trading Limited (NVT), engaged Thermal to design and produce foil heating elements in an attempt to break into the "heat-not-burn" tobacco market.

BAT had begun developing a product called "GLO" through NVT and a key part of the "GLO" device is the heating element that NVT engaged Thermal to design and produce. Thermal began production in 2016, making approximately 10,000 foil heaters per week. However, for NVT, this was not enough.

BAT, NVT, and Thermal started exploring ways to increase Thermal's output without increasing the foil heaters' unit cost. They eventually settled on an addition to Thermal's leased manufacturing facility, to be funded primarily by NVT. In 2017 NVT provided $4.085 million for the facility expansion, and construction began. In 2018 NVT provided an additional $204,529, and the expansion was completed.

Thermal did not report any of the $4.3 million paid to it by NVT for the leasehold improvements on its 2017 or 2018 Form 1120, U.S. Corporation Income Tax Return. Thermal's 2018 tax return included Form 8275, Disclosure Statement, that stated that it had received funds in the nature of nonshareholder contributions to its capital for 2017 and 2018 and that it was relying on Code Sec. 118(a) and the application of the Supreme Court's ruling and five-part test explained in U.S v. Chicago, Burlington, & Quincy Railroad Co. (CB&Q), 412 U.S. 401 (1973) as the bases for not reporting these funds as taxable income. Thermal did not deduct any depreciation on its returns for the portion of the leasehold additions funded by NVT.

In July 2021, the IRS determined deficiencies of $1,277,147 and $42,951 for Thermal's 2017 and 2018 tax years, respectively, and a Code Sec. 6662(a) accuracy-related penalty of $255,429 for 2017. While the IRS argued that Thermal was the owner of the leasehold addition funded by NVT, Thermal contended that NVT wanted Thermal to bear legal title even as NVT held an equitable interest in the leasehold addition, and that Thermal acceded as an accommodation to NVT. With respect to the $4.3 million paid by NVT for the leasehold improvements, Thermal argued that it was excludable from income under Code Sec. 118(a), which provides that in the case of a corporation, gross income does not include any contribution to the capital of the corporation.

The IRS countered that the exceptions to Code Sec. 118(a) found in Code Sec. 118(b) preclude a capital contribution determination. Code Sec. 118(b) provides that, for purposes of Code Sec. 118(a), except as provided in Code Sec. 118(c) relating to special rules for water and sewerage disposal utilities, the term "contribution to the capital of the taxpayer" does not include (1) any contribution in aid of construction or any other contribution by a customer or potential customer, and (2) any contribution by any governmental entity or civic group (other than a contribution made by a shareholder as such).

Analysis

The Tax Court held that Thermal had not carried its burden of proving that NVT owned the leasehold addition. The court concluded that, while there was no concrete evidence as to who owned the leasehold addition, three items directly evidenced Thermal's ownership: (1) Thermal paid the insurance and the taxes for the entire building, including the addition; (2) Thermal bore the risks relating to the leasehold addition while Thermal possessed it; and (3) the certificate of occupancy was in Thermal's name.

In determining if a transfer qualifies as a contribution to capital under Code Sec. 118(a), the court said it is important to determine, under the CB&Q decision, the intent of the transferor in making the transfer. However, when such intent is not explicit (and it often is not), the court needs to consider the following five requirements for a transfer to be a contribution to capital, as distilled by the Court in CB&Q: (1) the contribution becomes part of the transferee's permanent working capital structure; (2) the contribution is not compensation for specific, quantifiable services; (3) the contribution is bargained for; (4) the contribution must foreseeably result in a benefit to the transferee in an amount commensurate with its value; and (5) the contribution will be employed in, or contributed to, the production of additional income. Because the parties did not contest that the $4.3 million was bargained for, that it benefited Thermal in an amount commensurate with its value, or that it contributed to the production of additional income, the court only needed to consider the application of (1) and (2) to Thermal.

In determining if the contribution to capital became a permanent part of Thermal's working capital structure, the Tax Court found that it had been squarely established that NVT provided the funds for the sole purpose of building the leasehold addition on land leased by Thermal and that the leasehold addition was used by Thermal in its manufacturing operations. Thus, the court held that the $4.3 million contributed by NVT became a permanent part of Thermal's working capital structure and this requirement weighed in favor of finding a contribution to capital.

With respect to determining whether NVT's payments were really compensation for a service or an intent to make a capital contribution, the court found that because NVT had likened its investment in Thermal's leasehold addition to an advance payment on future foil heating elements, the funds were clearly meant as compensation for a service - future production volume at a higher output and a lower price per unit. Because NVT sought to obtain more foil heaters at a lower price, the court held that the $4.3 million NVT paid was compensation to Thermal and thus NVT did not have the requisite intent to make a contribution to capital excludable under Code Sec. 118(a).

Although the leasehold addition was not completed until late 2018, while under construction in 2017, manufacturing lines were brought on line one by one and production increased incrementally. Consequently, the court found that the accrual method required Thermal to include the $4.085 million received in 2017 on its 2017 tax return. With respect to the $204,529 received in 2018, Thermal had not earned it through performance in a prior year, nor was it otherwise due in 2017. Thus, it was includible on Thermal's 2018 tax return.

Finally, the court held that while Thermal's return position was incorrectly premised on NVT's ownership of the leasehold addition, Thermal had reasonable cause and acted in good faith and was thus not liable for the accuracy-related penalty.

For a discussion of what constitutes a nontaxable contribution to capital under Code Sec. 118, see Parker Tax ¶77,500.

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.