Thermal Circuits, Inc. v. Commissioner: $4.3M Leasehold Improvement Dispute

The $4.3 Million Question: Who Owns the Leasehold Improvements?

Thermal Circuits Inc. just learned the hard way that the Tax Court does not treat customer-funded leasehold improvements as a free pass to avoid $1.3 million in tax deficiencies and penalties. The company, which designs and manufactures foil heating components for British American Tobacco’s (BAT) heat-not-burn tobacco devices, received $4.3 million from BAT’s subsidiary to expand its Salem, Massachusetts manufacturing facility. But when Thermal failed to report the funds as income on its 2017 and 2018 tax returns, the IRS came knocking with a $1.28 million deficiency for 2017 alone, plus $255,429 in accuracy-related penalties. The core dispute hinged on whether these customer-funded improvements belonged to Thermal or were merely compensation for future production capacity—an issue that could have set a precedent for how companies account for customer-funded expansions worth millions. The stakes extended beyond Thermal’s balance sheet, touching on the broader treatment of customer-funded capital improvements in corporate taxation.

From Foil Heaters to Factory Expansion: The Story of Thermal Circuits and BAT

Thermal Circuits Inc., a Salem, Massachusetts-based manufacturer of foil heating components since 1961, found itself at the center of a high-stakes production dilemma in late 2016. British American Tobacco (BAT), through its subsidiary Next Vapor Technologies (NVT), sought to scale up production of its new "GLO" heat-not-burn tobacco device—a key component of which was the foil heater Thermal manufactured. NVT's demand for 200,000 foil heaters per week dwarfed Thermal's then-current capacity of just 10,000 units weekly.

Thermal's president and sole owner Anthony Klein, an engineer by trade, recognized the opportunity but also the existential risk. Meeting NVT's demand through overtime would have increased production costs by $1.81 per unit, eroding profitability. The solution required expanding Thermal's manufacturing footprint—adding chemical etching lines, dark room facilities, and office space. But with Thermal's existing leasehold facility already stretched thin, such an expansion would require substantial capital investment.

Negotiations between Thermal and NVT revealed starkly different risk appetites. Thermal, wary of becoming overly dependent on a single customer, initially sought a minimum production floor from NVT to guarantee future orders. NVT refused, instead proposing a damages clause that would penalize Thermal $1.81 for every unit short of 1.7 million annually—potentially amounting to $3.1 million in penalties. Thermal rejected this arrangement, fearing the financial exposure if NVT's demand waned after the expansion.

NVT ultimately agreed to fund the entire $4.3 million expansion cost, with Thermal contributing no capital of its own. The parties settled on a 33,000-square-foot expansion capable of producing 15 million foil heaters annually, with NVT issuing a purchase order captioned "Pre-payment for heater capacity 2018." The landlord, KAK Realty Trust, also contributed nearly $2 million toward a wastewater treatment facility to support the increased production.

As construction began in July 2017, the parties drafted a "Draft Framework Agreement" that would have given NVT ownership of all "NVT Property," including any facilities or equipment funded by NVT. The agreement specified that "Ownership of, and title to, [NVT] Property shall remain vested in [NVT]" and that Thermal would have no right to the property beyond its use in manufacturing NVT's heaters. However, this agreement was never executed.

Instead, the parties signed a Supply Heads of Terms Agreement (HoT Agreement) in May 2018 that defined "Dedicated Equipment" as any equipment funded by NVT, over which NVT retained ownership while Thermal bore all risk of loss. The agreement explicitly stated that "Title (ownership) [of the Dedicated Equipment] shall remain vested in NVT," though Thermal would possess and use the equipment exclusively for NVT's production needs.

By late 2018, the expanded facility—including 20,000 square feet of new manufacturing space and 10,000 square feet of office space—was complete and certified by the City of Salem. Thermal installed new production lines in stages, charging NVT on a cost-plus basis for the tools and machinery. The facility operated under this arrangement until 2021, when NVT abruptly terminated the relationship and demanded Thermal destroy the Dedicated Equipment it had purchased with NVT's funds. Thermal complied despite misgivings, leaving the expanded leasehold addition unused and seeking written permission from NVT to repurpose the space—permission that was never granted.

Throughout this period, Thermal treated the $4.3 million as a non-shareholder contribution to capital, excluding it from income on its 2017 and 2018 tax returns. The ambiguity over ownership of the leasehold improvements—whether they belonged to Thermal or NVT—would become the central issue in the subsequent tax dispute, with the IRS arguing that Thermal's receipt of the funds constituted taxable income.

The Tax Dispute: Capital Contribution or Compensation?

Thermal’s argument hinged on the assertion that the $4.3 million from NVT qualified as a non-shareholder contribution to capital under Section 118(a), which excludes from gross income any contribution to the capital of a corporation. Thermal relied on the five-part test established in United States v. Chicago, Burlington & Quincy Railroad Co. (CB&Q), 412 U.S. 401 (1973), to support its position. The company contended that NVT’s payment was intended to permanently enhance Thermal’s manufacturing capacity, becoming part of its working capital structure rather than compensation for services. Thermal further argued that the funds were not tied to specific performance metrics or future production volume, distinguishing the payment from taxable income under Section 61(a), which broadly defines gross income as all income from whatever source derived.

The IRS, however, framed the dispute as a classic case of Section 118(b) in action. The agency asserted that the $4.3 million was compensation for services or customer-financed construction, rendering it taxable income. The IRS emphasized that the funds were explicitly tied to Thermal’s expansion of manufacturing capacity to meet NVT’s demand for foil heaters, arguing that this linkage transformed the payment into consideration for future production rather than a capital contribution. The agency pointed to Treasury Regulation §1.118-1, which clarifies that money or property transferred to a corporation in exchange for goods or services rendered does not qualify for exclusion under Section 118(a). The IRS further contended that Thermal’s retention of ownership over the leasehold improvements—evidenced by insurance payments, tax assessments, and the certificate of occupancy in Thermal’s name—undermined its claim that NVT held an equitable interest in the property.

At the heart of the disagreement lay a fundamental disagreement over the nature of the transaction. Thermal viewed the payment as an unconditional capital infusion designed to strengthen its operational infrastructure, while the IRS saw it as a conditional payment directly tied to NVT’s commercial interests. The absence of explicit documentation memorializing NVT’s ownership of the leasehold improvements further complicated the dispute, leaving the court to weigh the parties’ competing interpretations of the agreements and the economic realities underlying the transaction.

The Court's Reasoning: Ownership, §118, and the CB&Q Test

The court’s analysis hinged on three pivotal determinations: who owned the leasehold improvements, whether the $4.3 million payment constituted taxable income under §61(a), and whether the funds qualified for exclusion under §118(a) despite the §118(b) exceptions. Each step required parsing the economic realities of the transaction, not just the contractual language.

Ownership of the Leasehold Addition: The Court’s Finding

The court rejected the IRS’s argument that NVT owned the leasehold improvements, finding instead that Thermal bore the indicia of ownership. The Tax Court has long relied on Grodt & McKay Realty, Inc. v. Commissioner to assess ownership of leasehold additions, examining factors such as who paid taxes and insurance, who bore the risk of loss, and whose name appeared on the certificate of occupancy. Here, Thermal paid the insurance and property taxes for the entire building, including the addition, and held the certificate of occupancy in its name. The court emphasized that NVT’s alleged equitable interest was not memorialized in any agreement, leaving Thermal as the undisputed owner of the leasehold addition. This conclusion was critical because it determined who had “complete dominion” over the $4.3 million accession to wealth.

§61(a) Gross Income: The Accession to Wealth

With ownership settled, the court turned to whether Thermal realized taxable income under §61(a), which broadly defines gross income as “all income from whatever source derived.” The Supreme Court’s decision in Commissioner v. Glenshaw Glass Co. established that gross income includes any “accession to wealth, clearly realized, and over which the taxpayers have complete dominion.” The court found that Thermal’s receipt of the leasehold addition—valued at $4.3 million—constituted such an accession. NVT could not compel Thermal to return the funds or restrict its use of the improvements, and Thermal retained full control over the property. The court cited Commissioner v. Indianapolis Power & Light Co., which held that a taxpayer has “complete dominion” over funds when it has unrestricted use and control. Thus, the $4.3 million was taxable income under §61(a).

§118(a) Contribution to Capital: The CB&Q Five-Part Test

Thermal argued that the $4.3 million was a non-taxable contribution to capital under §118(a), which excludes from gross income “any contribution to the capital of the taxpayer.” However, the court applied the five-part test from Chicago, Burlington & Quincy Railroad Co. v. United States (CB&Q), which requires that a contribution become part of the transferee’s permanent working capital structure and not be compensation for services. The court first addressed the “permanent working capital” requirement. It found that NVT’s funds were committed to building a leasehold addition that Thermal used in its manufacturing operations, effectively becoming a permanent part of its operational infrastructure. The court relied on cases such as Texas & Pacific Ry. Co. v. United States and AT&T, Inc. v. United States, which held that funds committed for investment in a business become part of permanent working capital.

The court then examined whether the payment was compensation for services, which would disqualify it from §118(a) treatment. The IRS argued that NVT’s payment was compensation for future production of foil heaters at a lower cost per unit. The court agreed, noting that NVT’s internal documents referred to the payment as a “Pre-payment for heater capacity 2018” and that NVT performed a cost-benefit analysis to recoup its investment after purchasing 2.5 million foil heaters. The court concluded that the funds were directly tied to NVT’s expectation of future production and cost savings, making them compensation rather than a capital contribution. This finding aligned with Detroit Edison Co. v. Commissioner, where the Supreme Court held that customer payments for infrastructure were compensation for services, not capital contributions.

§118(b) Exceptions: The “In Aid of Construction” and “Customer” Loopholes

Even if NVT had intended to make a capital contribution, the court ruled that the §118(b) exceptions applied. Section 118(b)(1) excludes from §118(a) treatment any contribution that is “in aid of construction” or made by a “customer or potential customer.” The court found both conditions satisfied. NVT’s funds were explicitly used to construct the leasehold addition, and NVT was a customer of Thermal at the time of payment. The court rejected Thermal’s argument that the funds were a capital contribution, holding that the §118(b)(1) exceptions operated as a statutory override. This ruling underscored the Tax Court’s willingness to apply the §118(b) exceptions expansively, limiting the scope of §118(a) exclusions for non-shareholder contributions.

Timing and Penalties: When to Report and When to Forgive

The court’s ruling on timing hinged on the accrual method’s requirement that income be recognized when “all the events have occurred which fix the right to receive such income and the amount thereof can be determined with reasonable accuracy.” Treas. Reg. § 1.451-1(a). The IRS argued that the $4.085 million received in 2017 and the $204,529 received in 2018 should be deferred until the leasehold addition was completed. The court rejected this, holding that the accrual method does not permit deferral based on performance milestones. Instead, the court applied the “earliest of” rule from Johnson v. Commissioner, 108 T.C. 448 (1997), which ties income inclusion to the date payment is received, due, or performance is rendered. Because the $4.085 million was paid in 2017—even as construction progressed incrementally—the court held it must be included in Thermal’s 2017 gross income. The $204,529 received in 2018, however, was not earned or due in 2017, so it properly belonged to 2018.

On penalties, the IRS asserted a 20% accuracy-related penalty under § 6662(a) for 2017, arguing Thermal negligently disregarded the rules by treating the NVT funds as a capital contribution. Section 6662(c) defines negligence as a failure to make a reasonable attempt to comply with the Code, while § 6664(c)(1) provides an exception if the taxpayer acted with reasonable cause and in good faith. The court emphasized that the penalty hinges on whether Thermal’s position was objectively reasonable, not whether it was ultimately correct. Thermal’s belief that NVT owned the leasehold addition—despite the court’s contrary ruling—was deemed reasonable given the language in the draft Framework Agreement and the HoT Agreement, which repeatedly reserved title to NVT-funded assets, including “facilities.” The court also noted Thermal’s consistent actions reflecting that belief: it did not claim depreciation on the NVT-funded portion of the leasehold addition, sought NVT’s permission to use the space, and complied with NVT’s instructions to destroy Dedicated Equipment. These actions demonstrated an honest, though mistaken, interpretation of the agreements, satisfying the reasonable cause defense. Thus, the court concluded Thermal had acted in good faith, and no accuracy-related penalty applied.

The Takeaway: Leasehold Improvements, Customer Funding, and the Limits of §118

The Tax Court’s decision in Thermal Circuits, Inc. v. Commissioner delivers a clear warning to taxpayers receiving customer-funded leasehold improvements: the $4.3 million at issue was taxable income, not a capital contribution under §118(a). The court’s holding hinges on the fundamental distinction between unconditional capital infusions and payments tied to future production—a distinction that grows increasingly narrow under §118(b)(1)’s broad exceptions. For taxpayers in industries like heat-not-burn tobacco, where customer-funded expansions are common, this case underscores the need for meticulous documentation of ownership and intent.

The court’s reasoning crystallizes three critical takeaways. First, customer-funded leasehold improvements are presumptively taxable when tied to future production, as the payments function as compensation rather than capital contributions. The IRS successfully argued that NVT’s $4.3 million payments were not "in aid of construction" under §118(b)(1) but rather inducements for Thermal to expand production capacity—a classic example of taxable income disguised as a capital contribution. Second, the §118(b)(1) exceptions are expansive; even payments that appear capital-like can fall outside §118(a) if they carry performance strings. Thermal’s failure to demonstrate unconditional ownership of the improvements—despite its good-faith belief—sealed its fate. Third, the court’s emphasis on indicia of ownership (insurance, tax treatment, risk allocation) provides a roadmap for future disputes. Taxpayers must treat customer-funded improvements as taxable income unless they can prove the payments were unconditional capital contributions, a burden that grows heavier with each §118(b) exception.

For the heat-not-burn tobacco industry, where manufacturers like BAT’s GLO often rely on customer-funded expansions to meet demand, this case is a cautionary tale. Customer payments for factory upgrades or equipment—even if framed as "contributions"—are likely taxable unless structured as true capital infusions. The court’s focus on economic reality over formality means taxpayers cannot rely on boilerplate agreements; they must document ownership transfers, clarify funding intent, and avoid tying payments to production milestones. The IRS’s victory here signals a broader crackdown on creative tax planning around customer-funded improvements, leaving little room for ambiguity. Taxpayers who fail to heed this warning may find themselves facing unexpected liabilities—and penalties—when the IRS comes knocking.