The $4.3 Million Label Problem.
July 2026
Every so often the Tax Court hands down an opinion that looks, at first glance, like a narrow quarrel over a single line on a corporate return — and turns out to be a lesson in something much larger. Thermal Circuits, Inc. v. Commissioner, T.C. Memo. 2026-29, is one of those. On its surface it is a fight about whether $4.3 million a manufacturer received from its largest customer was a tax-free contribution to capital or ordinary taxable income. Underneath, it is a lesson every family, every closely held business, and every trust settlor should absorb: the tax character of a payment is not determined by what you call it. It is determined by why it was actually paid, and the paper you leave behind either proves your story or destroys it.
That is the same discipline that governs asset protection, estate planning, and cross-border reporting. Different code sections, identical spine. Thermal Circuits is worth reading closely not because most of our clients manufacture foil heating elements, but because it shows — in unusually clean facts — how a court decides what a transfer really is, and how documentation can save you even when the characterization does not.
The facts: a customer who paid for a building.
Thermal Circuits, Inc. (“Thermal”) is a C corporation that designs and manufactures foil heating components. In 2013, British American Tobacco — through its subsidiary Nicoventures Trading Limited (“NVT”) — engaged Thermal to produce foil heating elements for “heat-not-burn” tobacco devices (Thermal Circuits, T.C. Memo. 2026-29, at 1–2 (Copeland, J.)). The relationship worked. By 2016, NVT wanted far more heaters than Thermal’s leased plant could produce, and it wanted them without paying more per unit (id. at 2).
The parties’ solution was to expand the factory. NVT agreed to fund an addition to Thermal’s leased manufacturing facility — new manufacturing space, an etching room, a darkroom, and offices. NVT paid $4.085 million in 2017 and a further $204,529 in 2018, for roughly $4.3 million total (id. at 2). Thermal reported none of it as income, took no depreciation on the improvements, and treated the money as a nonshareholder contribution to its capital, excludable under § 118(a) (I.R.C. § 118(a)). The IRS disagreed, and the case went to trial before Judge Copeland, who filed the opinion on March 30, 2026 (corrected version served July 7, 2026) (Docket Nos. 33027-21, 33035-21, consolidated with Anthony A. Klein and Barbara N. Klein v. Commissioner).
The first question: who owned the building?
Before a court can decide whether a receipt is income, it often has to decide who owns the thing received. Thermal’s core argument was that although it held legal title to the improvements “as a matter of convenience,” NVT held equitable title — so Thermal never really received anything (Thermal Circuits, T.C. Memo. 2026-29).
The court rejected this by applying the familiar indicia-of-ownership analysis from Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221, 1237–38 (1981). Tax ownership follows the benefits and burdens of property, not the label on the deed. And here the burdens all sat with Thermal: Thermal paid the insurance and property taxes on the entire premises, bore the risks of possession, and the certificate of occupancy was issued in Thermal’s name (id.). Whatever the parties told themselves about “convenience,” Thermal owned the addition.
That determination did the heavy lifting. Under § 61(a), gross income reaches “all income from whatever source derived,” construed broadly to capture every “accession to wealth, clearly realized, and over which the taxpayers have complete dominion” (Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955); exclusions narrowly construed, id. at 429–30). Because the leasehold addition belonged to Thermal, Thermal had received something of value — a building worth $4.3 million over which it had “complete dominion” — and that is textbook gross income (see Commissioner v. Indianapolis Power & Light Co., 493 U.S. 203, 210 (1990)). The only escape route left was § 118.
The second question: contribution to capital, or price?
Section 118(a) is short and generous: a corporation’s gross income “does not include any contribution to the capital of the taxpayer.” The doctrine has long recognized that even a non-shareholder — a municipality, a landowner, sometimes a customer — can contribute to a corporation’s capital tax-free, where the transfer is meant to enlarge the enterprise rather than to buy something.
The line between the two is drawn by the five-part test the Supreme Court articulated in United States v. Chicago, Burlington & Quincy Railroad Co. (CB&Q), 412 U.S. 401 (1973). For a payment to be a true contribution to capital, (1) it must become a permanent part of the transferee’s working capital; (2) it must not be compensation for specific, quantifiable services; (3) it must be bargained for; (4) the asset must benefit the transferee in an amount commensurate with its value; and (5) it must ordinarily produce additional income for the transferee (id. at 413; Thermal Circuits, T.C. Memo. 2026-29).
The parties agreed on factors three and four. The case turned on factor two — and Thermal lost decisively. The court found that NVT’s purpose was not to enlarge Thermal’s business for its own sake but “to obtain as many foil heaters as possible for the most economical price” (id.). NVT ran a cost-benefit analysis and calculated it would recoup its outlay after buying roughly 2.5 million heaters; it negotiated a damages clause in case Thermal underproduced; and — the detail that sealed the outcome — NVT captioned its own purchase order “Pre-payment for heater capacity 2018.” (id.) In the court’s words:
In this light, the funds were clearly to be 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, we hold that the $4.3 million it paid is compensation to Thermal.
Compensation is not a contribution to capital. Treasury Regulation § 1.118-1 says as much: money transferred “in consideration for goods or services rendered” cannot be excluded. The payment failed factor two, and § 118(a) was unavailable.
The belt-and-suspenders holding: § 118(b).
The court did not stop there. Even if the payment had somehow qualified as a capital contribution under the CB&Q factors, § 118(b) — as amended by the 2017 Tax Cuts and Jobs Act — independently disqualified it. Section 118(b)(1) carves out of the tax-free treatment any contribution made “in aid of construction” or by “a customer or potential customer” (I.R.C. § 118(b)(1); Thermal Circuits, T.C. Memo. 2026-29). The statute is disjunctive: tripping either prong is fatal, and NVT’s payment tripped both. It was money for construction, paid by the manufacturer’s single largest customer (id.).
This is the part practitioners must internalize. Pre-2017 law tolerated a good deal of “customer contributes to the utility’s plant” planning. TCJA closed that door for contributions after 2017. A payment from a customer that funds the recipient’s own facilities now starts life on the wrong side of § 118 and has to climb out — a climb Thermal Circuits shows is very steep.
The lesson that saved them: documentation and reasonable cause.
Here is where the opinion becomes genuinely instructive rather than merely cautionary. Thermal lost the characterization fight and had to include the full $4.3 million in income across 2017 and 2018 (id. at 13). But the IRS also asserted a 20% accuracy-related penalty under § 6662. On that, Thermal won.
Under § 6664(c), no accuracy-related penalty applies to any portion of an underpayment for which the taxpayer shows reasonable cause and that it acted in good faith — measured by whether it exercised “ordinary business care and prudence” (I.R.C. § 6664(c)(1); Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 98 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002); Treas. Reg. § 1.6664-4(b)(1)). The court found Thermal had. Its conduct was consistent, throughout, with a sincere belief that NVT owned the addition: Thermal used the equipment and the new space only to make NVT’s heaters; when NVT told it to destroy dedicated equipment, it complied despite misgivings; it sought NVT’s written permission before using the addition and, receiving none, left the space empty; and — tellingly — it claimed no depreciation on the NVT-funded portion, forgoing deductions it would have taken had it believed it owned the asset (Thermal Circuits, T.C. Memo. 2026-29). That pattern, the court held, “evinces an honest, though mistaken, belief that NVT owned the leasehold addition,” establishing reasonable cause and good faith (id.).
Read that sequence again, because it is the whole planning point. The same documentary record that lost Thermal the characterization argument — the purchase order captioned “Pre-payment,” the customer’s evident purchase intent — won Thermal the penalty argument, because Thermal’s own conduct was internally consistent with the position it took. It did not have it both ways; it behaved, start to finish, as though its reported position were true. Consistency between what you say a transaction is and how you act is worth real money.
Versus: substance that supports the label, and substance that betrays it.
| Attribute | Payment dressed up as the wrong thing | Payment whose substance matches its label |
|---|---|---|
| Governing question | What did the parties call it? | Why was it actually paid — and what does the conduct show? |
| Documentation | Papers contradict the reported position (e.g., “Pre-payment for capacity”) | Contemporaneous papers, filings, and conduct all point one direction |
| Ownership | Legal title asserted “for convenience”; burdens sit elsewhere on the story | Benefits and burdens genuinely track the claimed owner |
| Timing | Characterization chosen after the fact to fit a tax result | Character fixed at inception, before any dispute or audit |
| Outcome on the merits | Recharacterized against the taxpayer | Respected as reported |
| Outcome on penalties | Exposure, unless conduct was consistent | Reasonable-cause defense stands on a coherent record |
Why a trust-and-estate audience should care.
Thermal Circuits is a corporate income case, but its engine — substance over form, and characterization proven by contemporaneous documentation — runs through nearly everything we do for clients:
- Intra-family transfers. Whether a transfer is a completed gift, a loan, or disguised compensation turns on substance and paperwork, not on the family’s after-the-fact label. A “loan” with no note, no interest, and no repayments is not a loan when the IRS or a creditor examines it — the same way NVT’s “contribution” was not a contribution.
- Trust funding and control. A settlor who says an irrevocable trust owns an asset but continues, in substance, to insure it, pay its expenses, and enjoy it invites the identical Grodt & McKay benefits-and-burdens inquiry — and the identical collapse of the intended characterization. Genuine protection requires that ownership actually move, not that a document announce it has.
- Reasonable cause as an asset. The § 6664(c) holding is a reminder that a defensible, well-papered position taken in good faith is protective even when it ultimately loses on the merits. Structures built early, documented contemporaneously, and administered consistently generate exactly this kind of record. Structures improvised to fit a desired outcome generate the opposite — evidence against the taxpayer.
- Cross-border reporting. Mischaracterizing the nature of a payment or a transfer is where offshore-reporting problems begin. The discipline is the same: report the substance, keep the paper, and make sure the conduct matches the return.
The recurring Watchtower theme holds here without any strain. Protection and favorable tax treatment alike must be seasoned — the character of a transaction is far more defensible when it was fixed at inception, for a genuine purpose, than when it is retrofitted under the shadow of an audit or a claim. The record you build on a clear day is the record that speaks for you on a stormy one.
Conclusion.
Thermal Circuits believed, sincerely, that it had received a tax-free contribution to its capital. Its sincerity earned it relief from penalties. It did not, and could not, change the tax character of $4.3 million that its own customer had labeled a “pre-payment for heater capacity.” The court looked past the label the taxpayer preferred to the purpose the documents revealed — and taxed the payment for what it was.
The planning lesson is not that customer-funded expansions are always taxable, though after TCJA’s amendment to § 118(b) most such payments now will be. The lesson is older and broader: decide what a transaction really is before you paper it, paper it so the substance and the label agree, and then behave in a way that is consistent with both. That is how you keep the IRS from recharacterizing your transaction — and, if the characterization is ever close, how you keep the penalty off the table. It is the same discipline that makes a trust a trust, a gift a gift, and a plan a plan.