123

DAVID J. MAINES AND TAMI L. MAINES, PETITIONERS v. 

COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket No. 14699–12. Filed March 11, 2015. 

Ps received targeted economic development payments from 

the state of New York. New York calls these payments 

‘‘credits’’ and treats them as refunds for ‘‘overpayments’’ of 

state tax. All the credits required Ps to make some amount 

of business expenditure or investment in targeted areas 

within the state. One of the credits, the QEZE Real Property 

Tax Credit, is limited to the amount of past real-property tax 

actually paid. The other two credits, the EZ Investment 

Credit and the EZ Wage Credit, are not limited to past tax 

actually paid. All the credits first reduce a taxpayer’s state 

income-tax liability; any excess credits may be carried forward 

to future years or partially refunded. Held: The state-law 

label of the credits as ‘‘overpayments’’ of past tax is not 

controlling for Federal tax purposes. Because the EZ Investment Credit and the EZ Wage Credit do not depend on past 

tax payments, they are not refunds of past ‘‘overpayments’’ 

but rather are like direct subsidies. Because it does depend on 

past property-tax payments, the QEZE Real Property Tax 

Credit is treated like a refund of past overpayments. Held, 

further, the portions of the EZ Investment Credits and the EZ 

Wage Credits that only reduce Ps’ state-tax liabilities are not 

taxable accessions to wealth. However, any excess portions of 

the credits that are refundable are taxable accessions to 

wealth to Ps. Held, further, the portions of the QEZE Real 

Property Tax Credit payments that only reduce Ps’ state-tax 

liabilities are not taxable accessions to wealth. Refundable 

portions of the QEZE Real Property Tax Credit payments are 

includible in Ps’ gross income under the tax-benefit rule to the 

extent that Ps actually benefited from previous deductions for 

property-tax payments. 
124 144 UNITED STATES TAX COURT REPORTS (123) 

1The New York Constitution prohibits direct gifts to corporations or individuals from state funds. N.Y. Const. art. VII, sec. 8 (McKinney 2006). 

Such clauses, found in many state constitutions, present perhaps intentional difficulties for the sort of targeted economic development at issue in 

this case. See Peter J. Galie & Christopher Bopst, ‘‘Anything Goes: A History of New York’s Gift and Loan Clauses’’, 75 Alb. L. Rev. 2005, 2005– 

2006 (2012) (gift and loan restrictions strictly limit state and local government taxing and spending powers); Martin E. Gold, ‘‘Economic Development Projects: A Perspective’’, 19 Urb. Law. 193, 210 (1987) (constitutional 

prohibitions major limitation on economic development). We decide in this 

case only the possible federal-tax recharacterization of the refundable credits at issue here, and not any possible state-law recharacterizations. 2Section references that do not cite New York law are to the Internal 

Revenue Code in effect for the years in issue. All references to Rules are 

to the Tax Court Rules of Practice and Procedure. 

Ryan M. Mead, for petitioners. 

John M. Janusz, Kevin Michael Murphy, Justin G. Meeks, 

and Anne D. Melzer, for respondent. 

OPINION 

HOLMES, Judge: New York State uses extremely targeted 

tax credits as an incentive for extremely targeted economic 

development in extremely targeted locations. Those who 

receive these credits may be extremely benefited—even if 

they do not owe any state income tax, New York calls the 

credits overpayments of income tax and makes them refundable. David and Tami Maines say that none of the credits 

should be taxable because New York labels them ‘‘overpayments’’ of past state income tax, and they never claimed 

prior deductions for state income tax. The Commissioner disagrees and argues that these refundable credits are, in substance even if not in name, cash subsidies to private enterprise—and just another form of taxable income. 1

Background 

The New York Economic Development Zones Act offers 

state-tax incentives to attract new businesses and to encourage expansion of existing ones. N.Y. Gen. Mun. Law secs. 

955–969 (McKinney 2012). 2 In 2000 the program changed its 

name to the Empire Zones Program (EZ Program). The EZ 

Program provides incentives to stimulate private investment 

and business development, and tries to create jobs in impoverished areas in New York State. Businesses in Empire 
(123) MAINES v. COMMISSIONER 125

3Taxation of S corporations is under subchapter S of the Code, and taxation of partnerships is under subchapter K. S corporations and partnerships are similar in that they do not pay taxes themselves but rather pass 

through items of income and deduction to their shareholders or partners. 

Secs. 701, 1366(a)(1). As an LLC (which stands for limited liability company) with two or more members, Huron had a choice of how it would be 

taxed—the Code treats such an LLC as a partnership unless the LLC 

elects otherwise. Sec. 301.7701–3(b)(1)(i), Proced. & Admin. Regs. Huron 

did not elect otherwise. Even though they don’t pay taxes, however, both 

S corporations and partnerships do file information returns to report their 

income and deductions to their owners. See secs. 701, 6031, 6037. 

Zones have to apply to become certified EZ businesses. 

Certified EZ businesses qualify for certain EZ tax credits. 

A certified EZ business that meets specific employment tests 

may become a Qualified Empire Zone Enterprise (QEZE). 

N.Y. Tax Law sec. 14(a) (McKinney 2014). QEZEs are eligible 

for additional targeted tax credits. The various EZ credits 

require that the business stay put within a designated area 

and meet certain annual employment requirements. See, e.g., 

id. secs. 15(a) and (b), 16. 

The three credits at issue in this case are the QEZE Credit 

for Real Property Taxes, id. secs. 15, 606(bb), the EZ Investment Credit, id. sec. 606(j), and the EZ Wage Credit, id. sec. 

606(k). Eligibility for all the credits depends on a business’ 

meeting the requirements. EZ businesses that are corporatelevel taxpayers, get credits against their franchise-tax 

liability; EZ businesses that are passthrough entities, such as 

partnerships, S corporations, or LLCs taxed as partnerships, 

get credits against the personal income-tax liabilities of their 

partners or members. The taxpayers in this case, the 

Maineses, own two firms, Endicott Interconnect Technologies, Inc., and Huron Real Estate Associates. Endicott is 

an S corporation, and Huron is an LLC taxed as a partnership. 3 Therefore any reference to ‘‘taxpayer’’ refers to individuals such as the Maineses and not to corporate taxpayers; 

any reference to ‘‘shareholders’’ refers to shareholders in S 

corporations. 

Because eligibility for the credits depends on a business’ 

meeting specific requirements, the full credit amount is calculated at the entity level even for pass-through entities. A 

partnership, for example, would report the credit amount on 

its NY Form IT–204, Partnership Return. It would then 
126 144 UNITED STATES TAX COURT REPORTS (123) 

4The amount of credit and tax benefit that passes through to the 

Maineses is a consequence of the property tax Huron pays. Huron’s property taxes must be taken into account at the partnership level for its taxable year, and therefore its claimed property-tax expenses and the 

Maineses’ share of those expenses are partnership items. See sec. 

6231(a)(3); sec. 301.6231(a)(3)–1, Proced. & Admin. Regs. These credits— 

because they pass through to the Maineses—affect the Maineses’ federal 

tax bill. That makes them ‘‘affected items.’’ See sec. 6231(a)(5). The Commissioner may issue an affected-items notice of deficiency without opening 

and closing a partnership-level proceeding as long as the Commissioner is 

bound by the partnership items as reflected on the partnership’s return. 

See, e.g., Meruelo v. Commissioner, 691 F.3d 1108, 1109, 1117 (9th Cir. 

report to individual partners (or, in the case of LLCs, members; or, in the case of S corporations, shareholders) their 

distributive share of the ‘‘pass-through credits’’ on Form IT– 

204–IP, New York Partner’s Schedule K–1. An individual 

claims his share of these credits on credit-specific forms, such 

as Form IT–601, Claim for EZ Wage Tax Credit, or Form IT– 

606, Claim for QEZE Credit for Real Property Taxes. He 

then reports these amounts on his personal income-tax 

return, New York Form IT–201, Resident Income Tax 

Return, which results in credit amounts that reduce his individual income-tax liability and any refundable portion being 

paid by the state to him individually. The process is similar 

for other passthrough entities, such as S corporations. 

The first tax credit at issue here is the QEZE Real Property Tax Credit. N.Y. Tax Law sec. 606(bb). The formula for 

computing this credit starts with the amount of real-property 

taxes a QEZE paid, and depends on when the business first 

became a QEZE. Id. sec. 15(b)(1) and (2). The QEZE calculates the total credit amount based on the property taxes 

previously paid, and when the QEZE is a passthrough entity, 

it provides its partners or shareholders with a distributive 

share of the credit. Id. It was the taxes paid and the business 

activity of Huron and Endicott that caused New York to pay 

the credits, but New York does not distinguish between 

forms of business when passing out QEZE credits: Partners 

in a QEZE partnership or shareholders of a QEZE New York 

S corporation receive distributive shares of the credit and 

claim that amount on their individual returns. The amount, 

however, cannot exceed the real-property taxes paid, which 

in this case means the amount of real-property taxes that 

Huron or Endicott paid. See id. subsecs. (e) and (f–1). 4 It is 
(123) MAINES v. COMMISSIONER 127

2012), aff ’g 132 T.C. 355 (2009); Gustin v. Commissioner, T.C. Memo. 

2002–64. 

important to note that while the amount of the credit is 

based upon the amount of real-property tax paid, the credit 

is against the New York income-tax liability (or corporatefranchise tax liability) of the taxpayer who claims the credit. 

Id. subsec. (a). Any amount of an individual’s distributive 

share of the credit not used in a particular tax year to reduce 

an income-tax liability is treated as an overpayment of New 

York income tax. Id. sec. 606(bb)(2). New York State does not 

tax the refunded portion of the credit, but treats it as a 

refund of state income tax. Id. So to summarize, as a QEZE, 

Huron qualified for the credit based on the amount of property tax it paid, but it was the Maineses who claimed their 

distributive share of the property-tax credit on their individual returns and who used it to reduce their own incometax liability and receive a refund. 

The second credit at issue is the EZ Investment Credit. 

This credit is eight percent of the cost or other basis for federal income-tax purposes of tangible property in an Empire 

Zone and acquired or built while the area is designated as 

an Empire Zone. N.Y. Tax Law sec. 606(j)(1). To be eligible, 

the property must meet several requirements. It must be 

‘‘purchased’’ as defined in section 179(d), located in a New 

York State Empire Zone, depreciable under the Code with a 

useful life of four or more years, and fit into one of only five 

listed categories. N.Y. Tax Law sec. 606(j)(2) and (3). The 

credit is against income tax or the corporate franchise tax, 

and the taxpayer claiming the credit—in this case an individual partner or shareholder in an S corporation—may 

carry forward any unused portion of the credit or may 

receive fifty percent of the excess as a refund if the taxpayer 

qualified as an owner of a new business under N.Y. Tax Law 

sec. 606(a)(10). See id. subsec. (j)(4). 

The final credit at issue here is the EZ Wage Credit. Id. 

subsec. (k). An EZ business qualifies for the EZ Wage Credit 

if its jobs, employees, and employment terms meet certain 

requirements. As with the other two credits, the credit is 

against a corporate taxpayer’s franchise tax or an individual’s income tax. A pass-through EZ business reports to its 

partners or shareholders their distributive share of the EZ 
128 144 UNITED STATES TAX COURT REPORTS (123) 

5This case is one of eleven related but unconsolidated cases filed by New 

York residents arising from disputes about the federal tax treatment of 

Wage Credit, and those individuals claim it as a credit 

against the New York income tax on their personal returns. 

Any excess credit that remains after reducing an individual’s 

income-tax liability may be carried over or partially 

refunded. Id. subsec. (k)(5). 

The Maineses are partners in Huron and shareholders in 

Endicott, and their businesses responded to the incentives 

New York gave them. Huron qualified for the QEZE Real 

Property Tax, the EZ Investment, and the EZ Wage Credits. 

And Endicott Interconnect’s business likewise qualified it for 

the EZ Investment and the EZ Wage Credits. From 2005 to 

2007 Huron deducted local property-tax payments on its federal returns—specifically, on Form 8825, Rental Real Estate 

Income and Expenses of a Partnership or an S Corporation— 

reducing the amount of income reported to the Maineses on 

their Schedules K–1, Partner’s Share of Income, Deductions, 

Credits, etc. 

On their New York income-tax returns, Forms IT–201, the 

Maineses claimed no state withholding or estimated tax payments. But for 2005 they wiped out half their state incometax liability with nonrefundable state credits not at issue in 

this case and the other half with part of the refundable EZ 

credits; for 2006 and 2007, they wiped out their entire state 

income-tax liability with nonrefundable state credits. Thus 

for tax years 2005 to 2007, they had actually paid no state 

income taxes. 

But having done just what New York wanted, the 

Maineses reaped a bountiful harvest of the New York EZ 

credits for this period. And because they had little to no state 

income-tax liability in these years for the credits to offset, 

the refundable credits led to large ‘‘refund’’ payments from 

New York to the Maineses. 

Discussion 

The parties disagree about none of these facts, and both 

have moved for summary judgment. Their dispute is instead 

about whether these excess refundable state-tax credits are 

taxable income under federal law. It is a novel and purely 

legal question. 5
(123) MAINES v. COMMISSIONER 129

these credits. 6Though maybe not exactly—a taxpayer may find himself in different 

tax brackets in different years, for example. 7The rule is thus one of those odd bits of tax law that began in commonContinued 

A. Tax Benefits, State-Created Legal Interests, and Federal 

Characterization 

We begin with an introduction to the ‘‘tax benefit rule.’’ 

The need for this rule lies in our system of taxing income on 

an annual basis. The world doesn’t come to an end and then 

begin again on January 1 every year, so courts early on had 

to figure out what to do when a transaction looked one way 

at the end of a tax year but looked different in a later year. 

The classic example is a bad-debt deduction. Imagine a 

taxpayer who writes off the principal of a loan in January 

2000 because his debtor can’t pay. But then in September his 

debtor wins the lottery and repays the debt. No bad-debt 

deduction here, because the debt turned out not to be bad. 

But what happens if we move the hypothetical forward six 

months? The taxpayer writes off the loan in July 2000. 

Nothing changes before the end of the year, so the taxpayer 

is entitled to claim a bad-debt deduction. See sec. 166. But 

the debtor wins the lottery in February 2001 and repays the 

debt. 

Remember that in this second hypothetical, the taxpayer 

was getting a deduction for unrepaid principal. The return of 

principal is generally not includible in taxable income. See, 

e.g., Nat’l Bank of Commerce of Seattle v. Commissioner, 115 

F.2d 875, 876 (9th Cir. 1940), aff ’g 40 B.T.A. 72 (1939). And 

the taxpayer—from the perspective of the end of his tax 

year—quite properly took a bad-debt deduction. But before 

taxes isn’t he economically in the same position as the taxpayer in the first hypothetical? 

Of course he is. And the tax-benefit rule is how tax law 

squares the hypotheticals to reach the same result—more or 

less. 6 It tells us to look at the subsequent event (in these 

hypotheticals, the unexpected repayment of a loan) and ask: 

If that event had occurred within the same taxable year, 

would it ‘‘have foreclosed the deduction?’’ See Hillsboro Nat’l 

Bank v. Commissioner, 460 U.S. 370, 383–84 (1983). 7 If yes, 

the subsequent event is taxable. 
130 144 UNITED STATES TAX COURT REPORTS (123) 

law fashion in caselaw. In the early days of the income tax, it was unclear 

if the rule was valid. But then our predecessor, the U.S. Board of Tax Appeals, upheld the application of the rule in 1929, see Excelsior Printing Co. 

v. Commissioner, 16 B.T.A. 886 (1929), and the Fifth Circuit commented 

soon thereafter that the rule was a principle that ‘‘seems to be taken for 

granted,’’ Putnam Nat’l Bank v. Commissioner, 50 F.2d 158, 158 (5th Cir. 

1931), aff ’g 20 B.T.A. 45 (1930). The rule since then has become partially 

codified, see sec. 111, and is now settled as a background principle. For a 

history of the development of the tax-benefit rule, see generally Boris I. 

Bittker & Stephen B. Kanner, ‘‘The Tax Benefit Rule’’, 26 UCLA L. Rev. 

265 (1978), and Patricia D. White, ‘‘An Essay on the Conceptual Foundations of the Tax Benefit Rule’’, 82 Mich. L. Rev. 486 (1983). 

Easy enough in the bad-debt case—if the debtor in the 

second hypothetical had won the lottery in 2000 just like the 

debtor in the first hypothetical, the taxpayer would have 

been repaid and not entitled to a bad-debt deduction. 

Now let’s move on to state-tax refunds. As all federal taxpayers who itemize their deductions learn, a state income-tax 

refund has to be added to one’s federal taxable income in the 

year it’s received if one took a deduction for state income-tax 

payments for a preceding year. The logic is pretty straightforward. Imagine a taxpayer who pays $1,000 in state income 

taxes in year 1. His state (acting with unimaginable speed) 

sends him a $200 refund just before the stroke of midnight 

on New Year’s Eve. His state income-tax deduction is $800. 

Now imagine another taxpayer who pays $1,000, but who 

gets his refund only in year 2. Under the tax-benefit rule, he 

gets the $1,000 deduction on his year 1 tax return, but has 

to include the $200 refund in his year 2 income. Roughly 

equal cases get treated roughly equally. 

But what if someone who doesn’t itemize in year 1 gets a 

refund in year 2? The answer in that case is that he does not 

have to include his state income-tax refund on his year 2 

return, see Tempel v. Commissioner, 136 T.C. 341, 351 n.19 

(2011) (stating that state-tax refunds are not income unless 

the taxpayer claimed a deduction for them—for example, by 

itemizing for the previous year), aff ’d sub nom. Esgar Corp. 

v. Commissioner, 744 F.3d 649 (10th Cir. 2014): He got no 

deduction in year 1 for the state income tax that he paid, so 

he got no federal tax benefit. And without a federal tax benefit, he doesn’t have to bear a federal tax burden on a refund 

he receives in year 2. See, e.g., Clark v. Commissioner, 40 

B.T.A. 333, 335 (1939) (holding that so long as ‘‘petitioner 
(123) MAINES v. COMMISSIONER 131

8 After claiming at first that they never deducted New York real-property 

taxes on their federal income-tax returns, the Maineses admitted that this 

was incorrect—they never deducted New York real-property taxes personally, but Huron did on its federal return. One might think this would mean 

the Maineses’ receipt of the QEZE Credit for Real Property Taxes would 

trigger the tax-benefit rule. The Maineses argue, however, that because 

the New York tax code labels the QEZE Credit for Real Property Taxes 

credit as a credit against state income tax—and any refund of that credit 

as a refund of state income tax—we should instead focus on their federal 

deduction of state income tax. According to them, because the credit is 

nominally a refund of state income tax, its receipt can’t trigger the taxbenefit rule for them because they never claimed a deduction for payment 

of New York state income tax on their federal returns. 9 N.Y. Tax Law sec. 606(j)(4) (McKinney 2014) (labeling the Empire Zone 

Investment Credit refunds ‘‘overpayments’’); id. subsec. (bb)(2) (labeling 

the QEZE Credit for Real Property Taxes refunds ‘‘overpayments’’); id. 

subsec. (k)(5) (labeling the Empire Zone Wage Credit refunds ‘‘overpayments’’). 

neither could nor did take a deduction in a prior year,’’ any 

amount he receives the next year ‘‘is not then includable in 

his gross income’’); Rev. Rul. 79–315, 1979–2 C.B. 27. 

Now we can edge toward the real facts in this case. The 

Maineses stipulated that they took no deduction on their federal income-tax returns for the years at issue for state 

income tax paid in the preceding year. 8 They argue that 

their credits under the EZ Program are just like excess state 

income-tax withholding—they point out that the credits that 

New York gave them are defined by state law to be ‘‘overpayments’’ of state income tax. 9 They argue that they are like 

our nonitemizing hypothetical taxpayer, which means that 

they got a big state income-tax refund that they don’t have 

to include in their federal taxable income. 

We have to agree with the Maineses in part. They are correct that New York calls these payments ‘‘credits’’ and that 

New York says these ‘‘credits’’ are ‘‘overpayments’’ of state 

income tax. But in truth the Maineses didn’t pay this 

amount in state income tax. So the key question in this case 

becomes whether a federal court applying federal law has to 

go along with New York’s definition. 

The Maineses understand the importance of this question, 

and they argue that if New York State tax law calls these 

payments ‘‘overpayments’’ we have no power to call them 

something different. They point to cases like Aquilino v. 

United States, 363 U.S. 509, 513 (1960) (quoting United 
132 144 UNITED STATES TAX COURT REPORTS (123) 

States v. Bess, 357 U.S. 51, 55 (1958)), where the Supreme 

Court held that Federal tax law ‘‘ ‘creates no property rights 

but merely attaches consequences, federally defined, to rights 

created under state law.’ ’’ In Drye v. United States, 528 U.S. 

49, 58 (1999) (citing Morgan v. Commissioner, 309 U.S. 78, 

80 (1940)), the Court explained that we look first to state law 

to ‘‘determine what rights the taxpayer has in the property 

the Government seeks to reach, then to federal law to determine whether the taxpayer’s state-delineated rights qualify 

as ‘property’ or ‘rights to property’ within the compass of the 

federal tax lien legislation.’’ That is, state law creates legal 

rights and interests; federal law designates how those rights 

or interests will be taxed. See id. 

The Commissioner does not challenge these cases. And he 

also agrees that New York law labels the credits as ‘‘income 

tax credits,’’ and excesses or surpluses as ‘‘overpayments’’ of 

state income tax for state-tax purposes. But is a state’s legal 

label for a state-created right binding on the federal government? Here begins the disagreement. The Maineses contend 

that New York’s tax-law label of these excess EZ Credits as 

overpayments is a legal interest that binds the Commissioner 

and us when we analyze their taxability under federal law. 

The Commissioner warns that if this were true, a state could 

undermine federal tax law simply by including certain 

descriptive language in its statute. To use Lincoln’s famous 

example, if New York called a tail a leg, we’d have to conclude that a dog has five legs in New York as a matter of 

federal law. See George W. Julian, ‘‘Lincoln and the 

Proclamation of Emancipation,’’ in Reminiscences of Abraham 

Lincoln by Distinguished Men of His Time (Allen Thorndike 

Rice, ed., Harper & Bros. Publishers 1909), 227, 242 (1885), 

available at https://archive.org/details/ cu31924012928937. 

We have to side with the Commissioner (and Lincoln) on 

this one: ‘‘Calling the tail a leg would not make it a leg.’’ Id. 

Our precedents establish that a particular label given to a 

legal relationship or transaction under state law is not necessarily controlling for federal tax purposes. See Morgan, 309 

U.S. at 81; Patel v. Commissioner, 138 T.C. 395, 404 (2012). 

Federal tax law looks instead to the substance (rather than 

the form) of the legal interests and relationships established 

by state law. See United States v. Irvine, 511 U.S. 224, 238– 

40 (1994). 
(123) MAINES v. COMMISSIONER 133

10 Note that the rest of our opinion in Buffalo Wire Works dealt with the 

tax-benefit rule. We held that because none of the money was actually 

compensation for moving expenses, the taxpayer did not have a ‘‘recovery’’ 

of previously deducted moving expenses. Buffalo Wire Works, 74 T.C. at 

939. This was before the Supreme Court later invalidated the ‘‘recovery’’ 

test for the tax-benefit rule and replaced it with the ‘‘fundamentally inconsistent’’ test. Hillsboro Nat’l Bank v. Commissioner, 460 U.S. 370, 383 

(1983). Hillsboro does not affect our analysis in Buffalo Wire Works regarding state-law labels for federal tax purposes. 

Our decision in Buffalo Wire Works Co. v. Commissioner, 

74 T.C. 925, 936 (1980), aff ’d without published opinion, 659 

F.2d 1058 (2d Cir. 1981), supports this. In Buffalo Wire 

Works we had to determine the character of condemnation 

payments made by the city of Buffalo to the taxpayer. Under 

New York law, condemnation awards included compensation 

for land, building, and fixtures—and a court had to determine the compensation for the value of fixtures by calculating the cost of moving them. Id. at 927–28. The IRS 

argued that this meant that part of the condemnation award 

was a reimbursement for moving expenses (taxable in the 

case under the tax-benefit rule because the taxpayer had previously deducted the moving expenses) and not a payment 

entitled to nonrecognition treatment as an amount that was 

involuntarily converted into similar property. See sec. 1033 

(any gain from a condemnation award is not recognized if the 

money is reinvested in a similar property). 

We had to figure out whether the condemnation award for 

the taxpayer’s fixtures ‘‘should be treated for purposes of 

Federal income taxation as reimbursement of moving 

expenses or as money into which property has been converted.’’ Buffalo Wire Works, 74 T.C. at 934. And we concluded that, regardless of state-law labels, the economic 

reality of the payments showed them to be the latter. Id. at 

936–37. 10

We have to draw the same distinction here: The Maineses 

have a legal interest in the giant credits that New York law 

entitles them to. Those credits were paid to the Maineses, 

and nothing we say undermines New York’s decision to make 

them. But federal tax law has its own say in how to characterize those payments under the Code. Under New York law, 

to qualify for the EZ Investment Credit, a taxpayer must 

own a business that places in service qualified property in a 
134 144 UNITED STATES TAX COURT REPORTS (123) 

designated Empire Zone. To qualify for the EZ Wage Credit, 

a taxpayer must own a business that has full-time targeted 

employees who receive qualified EZ wages. Neither credit is, 

in substance, a refund of previously paid state taxes 

deducted under federal law. They are just transfers from 

New York to the taxpayer—subsidies essentially. 

The QEZE Real Property Tax Credit is different. Taxpayers receive a QEZE Real Property Tax Credit only if their 

business qualifies as a QEZE and pays eligible real-property 

taxes, and—this is important—the amount of this credit 

cannot exceed the amount of those taxes actually paid. The 

refundable portion of this credit is indeed a tax refund—it is 

in substance a refund of previously paid property taxes even 

if New York labels it a credit against state income taxes. And 

this means that our analysis of the EZ Investment and Wage 

Credits will be different from our analysis of the QEZE Real 

Property Tax Credit. 

B. The EZ Investment and Wage Credits 

Section 61(a) defines gross income as ‘‘all income from 

whatever source derived.’’ Payments that are ‘‘undeniable 

accessions to wealth, clearly realized, and over which the taxpayers have complete dominion’’ are taxable income unless 

an exclusion applies. Commissioner v. Glenshaw Glass Co., 

348 U.S. 426, 431 (1955). Section 61 is meant to extend to 

the full measure of Congress’s taxing power, and we have to 

construe exclusions from income narrowly. Commissioner v. 

Schleier, 515 U.S. 323, 327–28 (1995) (citing United States v. 

Burke, 504 U.S. 229, 248 (1992) (Souter, J., concurring)). 

Receipt of tax deductions or credits that just reduce the 

amount of tax a taxpayer would otherwise owe is not itself 

a taxable event, ‘‘for the investor has received no money or 

other ‘income’ within the meaning of the Internal Revenue 

Code.’’ Randall v. Loftsgaarden, 478 U.S. 647, 657 (1986). 

But what happens when those deductions or credits lead to 

a state income-tax refund greater than the taxes actually 

paid? Both parties point us to Tempel, where we stated that 

the amount of a state-tax credit that reduces a tax liability 

is not an accession to wealth under section 61. Tempel, 136 

T.C. at 351. Both parties agree with this. The parties disagree on what Tempel says about refundable portions of 
(123) MAINES v. COMMISSIONER 135

credits. Tempel involved the tax treatment of the sale of 

transferable Colorado state-tax credits that the taxpayers 

received for a donation of a qualified conservation easement. 

Id. at 342–43. Colorado allowed conservation easement 

recipients to use their credits to receive a limited refund up 

to $50,000 provided that the state had exceeded certain Colorado constitutional tax-collection limits. Id. at 343. We held 

that the mere receipt of these credits was not an accession 

to wealth, but that gain realized from selling them to a third 

party was capital gain. Id. at 349–52. 

The opportunity to receive $50,000 under certain circumstances made the credits potentially refundable, however, 

and this creates confusion and disagreement between the 

parties. The Maineses point to the potential refund and 

argue that Tempel held that the receipt of potentially refundable credits was not income to the taxpayer. This is true, but 

it misses the issue in this case. In the year in which the taxpayers in Tempel received and sold their credits, Colorado 

made it impossible for them to receive a refund. Id. at 349– 

50 (stating there is no evidence ‘‘that petitioners sold credits 

they could have otherwise used to receive a refund’’). We also 

stated it was ‘‘apparent that the transferred State tax credits 

never represented a right to receive income from the state,’’ 

while reiterating that credits are not an accession to wealth 

‘‘as long as they are used to offset or reduce the donor’s own 

State tax responsibility.’’ Id. at 351 n.17. Thus, far from suggesting that refunded portions of credits aren’t income, we 

noted that the credits in Tempel never led to cash refunds 

and emphasized that it is only the reduction of tax liability 

that is not income to the taxpayer. 

The Maineses are right that their EZ Investment and 

Wage Credits are distinct from the credits we discussed in 

Tempel—the Maineses did not receive cash in hand from 

selling them to a third party. But we don’t see much of a difference between the Maineses’ Investment and Wage Credits 

and those Colorado credits that we held taxable in Tempel. 

The key distinction—as we held in Tempel—is that a nontaxable credit is one that must be used to ‘‘offset or reduce’’ 

the taxpayer’s tax liability. With refundable portions of tax 

credits, taxpayers may receive cash payments in excess of 

their tax liability. 
136 144 UNITED STATES TAX COURT REPORTS (123) 

We therefore hold that this excess portion that remains 

after first reducing state-tax liability and that may be 

refunded is an accession to the Maineses’ wealth, and must 

be included in their federal gross income under section 61 for 

the year in which they receive the payment or are entitled 

to receive the payment unless an exclusion applies. See secs. 

101–140. And there is no exclusion from federal income tax 

simply because a payment comes from a state government. 

See Commissioner v. Kowalski, 434 U.S. 77, 81–82 (1977) 

(whether cash payments designated as meal allowances to 

state police troopers are excludable under section 119); Taggi 

v. United States, 35 F.3d 93, 95 (2d Cir. 1994) (taxpayer 

‘‘claiming an exclusion from income bears the burden of 

proving that his claim falls within an exclusionary provision 

of the Code’’); Dobra v. Commissioner, 111 T.C. 339, 349 n.16 

(1998) (holding taxpayers seeking an exclusion from income 

must bring themselves ‘‘within the clear scope of the exclusion’’). There is also no federal exclusion simply because an 

amount takes the form of a tax refund for state purposes. 

It is only the potentially refundable excess credits that 

must be included in gross income; and under the doctrine of 

constructive receipt, this is the case whether or not the 

Maineses elect to receive the excess or carry it forward. The 

regulations say that even if income is not actually reduced to 

a taxpayer’s possession, it is constructively received by the 

taxpayer if it is somehow made available to him so that he 

could draw on it if he wanted. Sec. 1.451–2(a), Income Tax 

Regs. We have formulated this concept by saying that ‘‘a taxpayer recognizes income when the taxpayer has an unqualified, vested right to receive immediate payment.’’ Martin v. 

Commissioner, 96 T.C. 814, 823 (1991). Income is not 

constructively received if the taxpayer’s right to control it is 

subject to substantial limitations. Sec. 1.451–2(a), Income 

Tax Regs. Here, there were excess tax credits left after the 

Maineses reduced their liability; the Maineses had a clear 

right to receive a percentage of this excess as a direct payment; and there were no limits on the Maineses’ ability to 

receive these payments. We must therefore hold that the 

Maineses have constructively received income equal to what 

they could have received as a direct payment even if they in 

fact chose not to do so. 
(123) MAINES v. COMMISSIONER 137

The Maineses also argue that the excess portion of the 

refundable state-tax credit is a return of capital and thus not 

income. See S. Pac. Co. v. Lowe, 247 U.S. 330 (1918). The 

return (or recovery)-of-capital doctrine makes nontaxable the 

repayment of an initial outlay. (For example, someone who 

buys stock for $1,000 and sells it for $2,000 pays tax only on 

the $1,000 gain.) The Maineses cite various revenue rulings 

and general counsel memoranda in support of their claim, 

but none of them justifies income exclusion in the present 

situation. See Rev. Rul. 78–194, 1978–1 C.B. 24; Rev. Rul. 

70–86, 1970–1 C.B. 23; I.R.S. Gen. Couns. Mem. 38247 (Jan. 

16, 1980) (citing I.R.S. Gen. Couns. Mem. 35731 (Mar. 14, 

1974)). The revenue rulings and the general counsel memoranda analyze situations where states refunded property 

taxes or rent payments that had not provided earlier tax 

benefits. In other words, their facts were just like those of a 

taxpayer who paid state taxes but didn’t itemize and therefore never benefited from the payments. 

The general counsel memoranda frame these payments as 

a ‘‘return of capital’’ rather than a tax refund because some 

of the recipients were renters and therefore never directly 

paid property tax; for them, the payments were a refund of 

rent expenses. I.R.S. Gen. Couns. Mem. 35731. And because 

rent payments are not deductible, the state refund was not 

for a previously deducted item and there was no tax-benefit 

issue. Thus, rather than standing for some escape from the 

tax-benefit rule, the memoranda clarify that such payments 

were tax-free returns of capital only because they restored a 

prior expense that had provided no previous tax benefit. See 

id. 

In this case, it’s unclear if the Maineses claim the credits 

are a tax-free return of capital because they are a return of 

property tax, a return of income tax, or some other return of 

capital. Their argument fails regardless. The Maineses didn’t 

pay any income tax to New York in 2005, 2006, and 2007. 

Therefore the credits can’t be a ‘‘return’’ of state income tax. 

They did pay property tax (through Huron), but they also 

benefited by deducting those payments (through Huron). This 

means the credits can’t be a tax-free return of capital. And 

while the amount of the investment credits takes into 

account the costs of acquiring and improving real estate 

(which are undoubtedly ‘‘capital’’ expenses), the authorities 
138 144 UNITED STATES TAX COURT REPORTS (123) 

that the Maineses cite involve the return of previously nondeducted property tax and rent payments, and do not suggest 

that payments like those at issue in this case are also a taxfree ‘‘return of capital.’’ This argument is, in any event, also 

underdeveloped on a summary-judgment motion—neither 

party presented any evidence, for instance, of whether the 

Maineses already received some tax benefit (such as depreciation deductions) for their capital outlays on real property. 

The Maineses also contend that their credits are excludable from their taxable income as welfare. The Commissioner 

has long held that certain payments from social-benefit programs that promote the general welfare are not includible in 

gross income. See Rev. Rul. 2005–46, 2005–2 C.B. 120 (certain payments promoting general welfare are excludable, but 

disaster-relief payments to businesses are not excludable). To 

qualify for the general-welfare exclusion, a payment must (1) 

be made from government funds, (2) promote the general 

welfare (generally based on need), and (3) not be compensation for services. Id. Grants from welfare programs that don’t 

require recipients to show need have not qualified for the 

general-welfare exclusion. See Bailey v. Commissioner, 88 

T.C. 1293, 1300 (1987) (denying the exclusion for payments 

from a facade grant program when the taxpayer only had to 

show ownership and building code compliance to qualify). 

Critics of programs like New York’s might call them ‘‘corporate welfare.’’ But that’s just a metaphor—the credits that 

New York gave to the Maineses were not conditioned on 

their showing need, which means they do not qualify for 

exclusion from taxable income under the general-welfare 

exception. See also, e.g., Rev. Rul. 2005–46 (holding that 

state grants for expenses incurred by businesses that agree 

to operate in disaster areas are not excludable under the 

general-welfare exclusion). 

We therefore hold that portions of the excess EZ Investment and Wage Credits that do not just reduce state-tax 

liability but are actually refundable are taxable income. 

C. The QEZE Real Property Tax Credit 

The Maineses’ QEZE Real Property Tax Credit is different 

because it was limited to the amount that Huron had actually paid in real-property taxes. As we’ve already discussed, 
(123) MAINES v. COMMISSIONER 139

11 Recall that whether or not the Maineses choose to receive the refundable portion of the credit, they are in constructive receipt of it and therefore must include it in their gross income. 

the tax-benefit rule and section 111 are what we use to 

answer this question. Under that rule and that section, a 

taxpayer is allowed to exclude a refund from his income if, 

but only if, he never got the benefit of a corresponding deduction for an earlier year. 

The parties agree that Huron paid property taxes in 2005– 

07 and that it deducted these taxes on its federal returns. 

See sec. 164(a)(2). On its Forms 8825 Huron deducted property taxes from its gross receipts to arrive at its net realestate income. Huron then calculated the Maineses’ distributive share of its net real-estate income and reported it to the 

Maineses on their Schedule K–1. The Maineses reported this 

amount on their Form 1040 on the line for partnership 

income. Because Huron had deducted its property tax to calculate its net real-estate income, the amount of net realestate income passed through to the Maineses was smaller 

than it would have been had property tax not been deducted. 

This decreased amount of passthrough income led to a 

smaller taxable income reported by the Maineses on their 

individual return, and thus smaller tax liability. This 

decreased tax liability is a benefit to the Maineses, and their 

receiving a cash refund of these previously deducted taxes is 

fundamentally inconsistent with the previous deduction—the 

distributive share of the passthrough QEZE Real Property 

Tax Credit that belonged to and was claimed by the 

Maineses, even though it was Huron that paid the underlying property tax at the entity level. See supra note 3. 

Because the cash refund is fundamentally inconsistent with 

Huron’s previous deduction, the tax-benefit rule applies. This 

means that any refundable portion of the QEZE Real Property Tax Credit that remained after first reducing the 

Maineses’ state income-tax liability is taxable as income. 11

The exclusionary aspect of the tax-benefit rule under section 

111(a) does not apply here to the extent that the decreased 

pass-through income from Huron reduced the Maineses’ federal tax liability. 

It is of no consequence that it was Huron that paid and 

deducted the property taxes while it is the Maineses who are 
140 144 UNITED STATES TAX COURT REPORTS (123) 

12Taxation of a C corporation is under subchapter C of the Code. C corporations (which include most large corporations) do pay tax at the corporate level, unlike S corporations. 

receiving the refundable credit. The Maineses needn’t have 

been the ones that personally claimed the earlier deduction 

if their tax-free receipt of the credit is fundamentally inconsistent with the earlier tax treatment. In Frederick v. 

Commissioner, 101 T.C. 35, 36 (1993), we faced a similar 

situation when a C corporation 12 deducted interest expenses 

before changing to an S corporation and passing through 

recovered interest expenses to its shareholders. Although the 

corporation initially claimed the deduction, we held that the 

tax-benefit rule required inclusion of the recovered expenses 

by S corporation shareholders because tax-free recovery of 

those expenses was fundamentally inconsistent with the previous deduction that lowered the corporation’s income. Id. at 

42–43. In reaching this conclusion, we noted that section 111 

is not limited to cases where the same person receives both 

the deduction in the earlier year and the recovery in the 

later year. Id. at 44 n.10. 

f 

An appropriate order will be issued.