County Hopeful That USDA Determination Will Convince IRS To Reverse Septic Replacement Grant Taxes

The U.S. Department of Agriculture may have given hundreds of South Fork homeowners who upgraded their septic systems in recent years, or are planning to in the near future, an early Christmas present.

The USDA last week issued a ruling, through Agriculture Secretary Tom Vilsack, that septic upgrade grants issued by the county to offset the costs of installing nitrogen-reducing septic systems should not be counted as taxable income.

Suffolk County Executive Steve Bellone’s administration, which has been pressing to get the improvement program declared nontaxable since the county comptroller’s office raised the issue, celebrated the announcement by the USDA last week.

Officials are now scrambling to get clarifications from the IRS itself that the rebates do not have be declared as taxable income before 1099s for 2022 are sent out.

“The secretary of agriculture responded to the county’s petitions from March 2021 with the determination that the grants are intended for conservation of natural resources and shouldn’t be considered part of the recipient’s gross income,” said Peter Scully, the deputy county executive who has spearheaded the county’s massive water quality improvement effort since Bellone took office in 2012. “There is a section of the Internal Revenue Service code that says that if a grant is intended to benefit the environment, and is not a personal benefit, it should be excluded from taxable income. That is something we have always thought this program easily met.”

Nonetheless, it has taken four years of government maneuvering to get something in writing that declares the grants nontaxable.

County officials spent three years of back-and-forth with the IRS — which, after initially saying the rebates should be taxed, had indicated that it would reverse that stance, then balked at the reversal and left the tax requirement in place — before asking Senator Charles Schumer for help in expediting the matter.

“We thought they had said OK, but then, all of a sudden, they reversed themselves for reasons unknown,” Schumer said in June of the IRS’s waffling on eliminating the rebate taxation. “So we’re gonna pull a rabbit out of a hat. We have a new way to go around the IRS. It’s called the U.S. Department of Agriculture.”

Now, County Executive Steve Bellone’s administration is scrambling to clarify whether the IRS needs to issue its own declaration, or if the USDA ruling is enough to wave off the issuance of 1099s, which would be mailed out by the county comptroller’s office in January.

The septic rebate program has been an integral part of one of the Bellone administration’s most important policy initiatives, dubbed “Reclaim Our Water.” Central to the program is addressing chronic nitrogen pollution of tidal and freshwaters from more than 360,000 aging home septic systems that leach human waste into groundwater, which then carries into surface waters of bays and ponds, where the nutrients spark algae blooms.

Since 2017, the septic rebate program has paid out $24 million in grants, initially of $11,000 and now up to $30,000, to homeowners who install modern septic systems that reduce nitrogen in the wastewater before it is released into the ground, but can cost as much as $40,000.

The funding for the grants comes from a mixture of county and state funding, both administered by the county.

The five East End towns also have their own rebate programs, funded by real estate sales taxes through the Community Preservation Fund, that offer an additional $20,000 to residents who make the upgrades as a supplement to the county grants.

Thus far, the two South Fork towns have abided by the IRS’s earlier position on the county program and issued 1099s for the grants they’ve awarded — even though the business offices of both Southampton and East Hampton have said they disagree with the provision. Whether or not to declare the grants taxable is up to the individual awarding agencies, and if the IRS were to reverse its thinking on the county grants program, the towns could choose to immediately take the same approach to their grants.

The county executive’s office has been fighting against the taxation of the grants for four years — ever since County Comptroller John Kennedy took the unusual step of alerting the IRS to the grant program and asking the federal tax behemoth for a rare “private letter” determination of whether the grants should be taxed.

In 2020, the federal agency said the grants should be counted as taxable, because the homeowners who received them held “oversight” of how the money was spent, since they chose the contractors who did the work — even though the grants are paid directly to the contractors and not to the homeowner.

The result was thousands of dollars in additional tax bills on the additional income. And some residents, county officials have lamented, were pushed by the revenue bump into higher tax brackets that increased the taxes they owed on other income unrelated to the septic grants.

“Some seniors saw their Social Security taxed for the first time, property tax exemptions were affected, families saw college aid applications impacted — there were a lot of impacts from this that affected a lot of residents negatively,” Scully said.

The Bellone administration has placed the blame square at Kennedy’s feet, accusing the Republican comptroller of foisting economic punishment on hundreds of county residents for no other reason than political chicanery. The comptroller was in the midst of his own ultimately failed campaign to unseat Bellone when he alerted the IRS to the grant program.

“No other program similar to ours has ever sought out an IRS special letter — it was only because of the comptroller engaging the IRS and coaxing them into determining that [the grants] were taxable,” Scully said. “It’s highly unusual for an elected official to work so hard to impose a new tax on their constituents.”

Kennedy has said that he was simply looking out for the interests of the county, which he said could have landed in hot water with the IRS if it did not apply tax policy correctly.

He has also said that the recent declaration by the USDA has not changed how his office will look at the grants, because the IRS has not yet said otherwise. New 1099s for grants issued in 2022 will begin going out in January.

But the comptroller has also said that if the IRS were to rule the rebate grants should not have been taxable, his office would help residents amend their back tax returns and see refunds. “And if I have to, I would try to hustle up some pro bono accountants to assist with the filing of amended returns,” he said in 2019.

If the taxation issue was intended to hobble the septic replacement program, the effects seem to have been limited. Applications to the program have continued to flow in, and the county has issued just under 900 grants, with another 1,000 approved and 2,000 applications waiting in the wings for funding. More than half of those applications have come from South Fork homeowners.

The program, which uses both county funding and a state fund specifically for septic system replacements, has paid out $24 million in grants, awarded another $6 million thus far, and has another $25 million more still available for grants in the approval pipeline. Scully said that he expects lifting the tax burden will accelerate the pace of applications, especially on the South Fork.

“Awareness is greater, the local governments are engaged, and the availability of town grants is an additional incentive,” he said. “Once we get this 1099 issue resolved, there is going to be even greater interest.”