IRS – POTs and PANs

Are Broadband Grants Taxable?

Casey Lide of Keller & Heckman wrote a recent blog that warns that federal grant funding might be considered as taxable income by the IRS. This would be a dreadful outcome for any taxable entity that receives the grant funding since it would create a huge tax liability that would have to somehow be covered outside of the grant funding. This would not affect just the big telcos and cable companies but also the many small telephone companies and cooperatives which are also taxable.

This is not a new issue. There were a lot of questions about federal grants being taxable in 2009 when the NTIA awarded BTOP and BIP grants that were the result of the stimulus spending that came out of the recession. The IRS eventually declared a ‘safe harbor’ for those grants, meaning that it agreed to not tax the grant funding. But the threat of possible taxation stopped many of my commercial clients from pursuing those grants in 2009.

Lide points out that the IRS has always presumed that grant funding is income to the entity receiving the grant and is taxable. Consider a common type of federal grant such as when a research lab gets a grant to pay for the salaries of researchers. Such a grant has always been considered to be taxable income to the lab. The research lab doesn’t worry about this because when it spends that money for salaries, the expenses are deductible from the income, and the lab doesn’t incur any net tax liability. This is one of the reasons that this kind of grant is often awarded each fiscal year to give the grant recipient a chance to spend the grant money in the year the income is received.

But grants given to build infrastructure are different. If a corporation accepts a $10 million grant to build fiber, it cannot expense the fiber immediately to offset the income from the grant. IRS rules have always insisted that hard assets are written off over the economic life of the asset using depreciation expense. I haven’t checked lately, but the IRS suggested tax life for fiber has been set at 25 years, meaning that one-twenty-fifth of the cost of the fiber is recognized as an expense each year over 25 years.

In this example, the corporation that accepted the $10 million grant would be saddled with a $10 million revenue and only be able to wipe out a small portion of it in the first year using depreciation. That would create an instant federal tax liability of 21% on the difference between the grant and one year of offsetting depreciation expense, plus whatever state incomes taxes would be owed. The corporation could not use the grant funds to cover the tax liability – grant money can only be used to build infrastructure. The corporation would eventually see the benefit of depreciation on future taxes, but that relief would be glacially slow over 25 years – it would not stop them from having to write a big check to the IRS this year.

Lide points out the way that the IRS got around this rule with the 2009 grants. There was a legal case in the 1950s, Brown Shoe Co., Inc. v Commissioner where the courts rules that grant funding received by a shoe company for keeping their factory operating was not taxable since none of that money was used to enrich the owners of the business. The IRS was able to make this same determination with the BTOP and BIP grants because, by definition, none of the money was used to enrich the owners of corporations since it was all spent to build infrastructure.

Lide believes that there have been changes in the 2017 Tax Cuts and Jobs Act that might make it impossible for the IRS to make that same ruling for current federal grants. Congress could have avoided this issue by explicitly saying that the new grants aren’t taxable – but that’s not in the various laws.

This is very distressing news for a corporation that has already accepted grant funding from the CAREs Act or from ARPA funds because they might be facing an unexpected tax liability. I know cooperatives and telephone companies that have already accepted some of these funds and who will be shocked if this interpretation holds to be true. One of the problems we have currently in dealing with these kinds of issues is that the IRS is running several years behind and won’t have yet dealt with a tax return from a corporation receiving recent the latest infrastructure grants.

As a further word of warning, this same issue would apply to anybody accepting state infrastructure grants. A state would have to take positive action to forgive the grant from state income taxes, but that would not shield state grant revenue from federal tax liability. Any taxable entity that has already received CAREs or ARPA funding, or anybody thinking about taking ARPA or BEADs funding to reach out to legislators on the issue. It may turn out that Congress might be the only one who can fix this – they certainly didn’t intend for anybody building rural broadband to incur a huge tax penalty. If this doesn’t get resolved, many of the carriers who are planning on using grants to solve the rural broadband gap might have to drop out of the pursuit of grants.

Economic Lives of Fiber Assets

One thing that anybody who builds a fiber network needs to deal with at some point is depreciation expense. Fiber networks are expensive and depreciation expense is a key component for measuring profitability and success. This is even true for non-taxable entities if you still create financial reports that include depreciation.

Companies differ in their approach to depreciating their assets. If the owner is a taxable corporation or cooperative they may prefer higher depreciation expense in the early years to shield the business from income taxes. But other owners care a lot about what their financial reports say and I know some fiber network owners that like lower depreciation. Accountants all understand that depreciation is a non-cash expense, but this is a nuance that is often lost on the public or the non-sophisticated reader of financial statements.

My job allows me see the books of a lot of different kinds of telecom entities and I see that depreciation rates used for telecom assets vary widely. There was a time when the FCC and state commissions set depreciation rates for big companies, and the rest of industry usually followed. But today a fiber provider is free to set depreciation lives within a surprisingly wide range.

There is only one authoritative source for depreciation lives which is from a bulletin published by the IRS in 2015. That bulletin establishes a baseline for depreciation for tax purposes for fiber networks that assumes a conservative and short life for fiber assets. For example, the IRS life for fiber cable is 24 years. At the other end of the scale, I have clients who are using a 40-year life on fiber. From an accounting perspective this wide range is like night and day.

In my experience the economic lives suggested by the IRS are ridiculously short. There was a time in the 1980s when a 20 to 25-year life for fiber was probably reasonable. The early generations of fiber cable had manufacturing flaws that allowed small cracks to develop over time that eventually cause the fiber to become opaque and lose usefulness. Most of the fiber built in those days has deteriorated over the years and has been retired or is of limited use today.

But the manufacturing process for fiber cables has improved drastically in each succeeding decade. I’ve talked to engineers at the fiber manufacturers who estimate that today’s fiber cables might easily last for 50 to 75 years as long as it’s installed properly and not unduly stressed. And there is speculation that fiber might last even longer – we’ll just have to wait and see.

The same thing is true for fiber electronics. Thirty years ago electronics in general were not as well made or as robust as today. There were large clunky circuit cards that expanded and shrunk in outside use and then eventually went bad. And these cards were full of individual components that could fail. But today a lot of the brains of electronics is embedded in chips that can last for a long time.

I can remember back in the 1990s when the engineering mantra was that you designed electronics to last from 7 to 10 years. Within that time frame the equipment would either start having operational issues or else the manufacturer would stop supporting it. But today’s electronics are much hardier and more reliable. I have several clients that still operate the first generation BPON fiber network networks. The electronics on these networks were made 12 – 15 years ago and are still going strong, and during that time they have had almost no failures. But most companies used depreciation lives for the BPON electronics of between 7 to 10 years. The same thing is true with the electronics used to power backbone networks. I have clients still operating networks built 15 years ago at twice the expected economic life.

So my advice to clients is that if they they are not stuck with whatever deprecation rates they are using. If they have reasons to might want shorter or longer depreciation lives there might be a justification for changing the depreciation rates. When I first got into the industry everybody used rates within a narrow range, but today there is a huge amount of flexibility in settling depreciation rates.

If your financial statements are audited then your auditor might want a professional opion of why it’s okay to change rates. But there is a huge amount of empirical data to support using longer lives for both fiber and electronics. And if you want to shorten lives it’s fairly easy to point to the IRS rules.

Accounting is not supposed to be this flexible and one would expect the industry to have a more consistent range of depreciation practices. But once the regulators stepped out of the business of regulating depreciation lives it’s been the wild west from an accounting perspective. So if you don’t like what depreciation expense is doing for you, contact me and I can help you find a better answer.

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