Imagine your biggest customer walks in and offers to pay for your factory expansion. No loan, no equity stake, no strings attached in writing beyond "we get first dibs on more of your product." You take the money, build the extra manufacturing space, and assume it was simply a smart customer investing in its own supply chain. Then a few years later the IRS shows up and says: that $4.3 million check was taxable income, and you owe tax on all of it — the year you got it, not the year you spent it.
That's exactly what happened to a small foil-heating-element manufacturer in Thermal Circuits, Inc. v. Commissioner, T.C. Memo. 2026-29, decided July 7, 2026. It's a narrow-sounding case about leasehold improvements, but the underlying scenario — a customer bankrolling a supplier's capacity expansion — is common well beyond one niche manufacturer, and the Tax Court's reasoning is a roadmap for how not to structure (or book) a deal like this.
The Deal: A Customer Pays for Your Growth
Thermal Circuits, Inc. manufactures foil heating components. Its primary customer, Nicoventures Trading Limited (NVT), wanted to significantly increase its order volume without absorbing a higher per-unit price. The two companies negotiated an expansion of Thermal's leased manufacturing facility — new production floor, an etching room, a darkroom, and additional office space — so Thermal could scale output to meet NVT's demand.
NVT funded the buildout directly: $4.085 million in 2017 and another $204,529 in 2018. Some manufacturing lines went live while construction was still underway. On paper, this looked like a straightforward win-win: NVT locked in supply at a lower unit cost, and Thermal got a facility upgrade it likely couldn't have afforded on its own.
Thermal's accounting treatment reflected that optimistic read. It never reported the $4.3 million as income. Instead, it treated the payments as a non-shareholder contribution to capital under Internal Revenue Code Section 118(a) — the provision that, in limited circumstances, lets a corporation receive money or property tax-free if it's genuinely a capital contribution rather than compensation. Consistent with that position, Thermal never claimed depreciation on the improvements either, since you can't depreciate an asset you're treating as someone else's property.
The IRS disagreed on both counts, and the Tax Court sided with the IRS.
Who Actually Owned the Improvements?
The threshold question the court had to answer wasn't really about tax law at all — it was about property law. Before you can decide whether a payment is taxable income, you have to know who owns what got built with the money. If NVT owned the improvements and simply let Thermal use them, the analysis looks very different than if Thermal owned improvements that someone else paid for.
The court applied the traditional multi-factor test for beneficial ownership (drawn from Grodt & McKay Realty, Inc. v. Commissioner) and found the facts stacked entirely in one direction:
- Thermal — not NVT — paid the insurance and property taxes on the entire premises, including the new construction.
- Thermal held the certificate of occupancy in its own name.
- Thermal bore the risk of loss and the burdens of possession, as the actual leaseholder of the facility.
NVT's contractual label calling the buildout "NVT Property" wasn't enough to overcome those substantive facts. The court concluded Thermal owned the improvements — which meant Thermal, not NVT, was the party that had to explain why receiving $4.3 million in customer cash wasn't taxable.
Section 118 Doesn't Cover Customer Money Anymore
Section 118 has always been a narrow exception to the broad rule — dating back to Commissioner v. Glenshaw Glass Co. — that gross income includes any "accession to wealth" a taxpayer clearly realizes and controls. The 2017 Tax Cuts and Jobs Act narrowed Section 118 further, adding language that expressly excludes contributions from "any customer or potential customer" and any contribution "in aid of construction" from the definition of a tax-free capital contribution. Congress's target was mostly government economic-development grants, but the customer carve-out landed squarely on situations like Thermal's.
Even setting the statutory carve-out aside, the court also walked through the older five-factor judicial test for a non-shareholder capital contribution (from United States v. Chicago, Burlington & Quincy Railroad Co.), which generally asks whether the transfer becomes a permanent part of the recipient's working capital, isn't compensation for goods or services, and is motivated by something other than a direct, particular benefit to the party paying. Thermal's case failed on the compensation prong. The evidence showed NVT had run a cost-benefit analysis before agreeing to fund the buildout, expecting to recoup its investment through the lower per-unit heater pricing Thermal would be able to offer once the expanded facility was running. That's not a philanthropic capital contribution — it's a customer paying in advance for a better deal on future purchases. The court put it plainly: "the $4.3 million it paid is compensation to Thermal."
Once the funds were compensation rather than a contribution, ordinary Section 61 principles took over: it was income, full stop, in whichever year Thermal — as an accrual-method taxpayer — earned it. That meant $4.085 million of taxable income in 2017 and $204,529 more in 2018, regardless of when the cash was actually spent on construction.
The One Bright Spot: No Penalty
Thermal didn't escape the tax bill, but it did escape the 20% accuracy-related penalty under Section 6662(a) that the IRS also sought. The court found Thermal had exercised "ordinary business care and prudence" in reaching its (incorrect) conclusion. The contract itself repeatedly referred to the improvements as "NVT Property." Thermal never claimed depreciation, used the space exclusively to serve NVT, and had tried to negotiate release rights consistent with someone else owning the asset. That was enough to show an honest, good-faith — if ultimately wrong — belief about who owned what.
The lesson here cuts both ways: contract language wasn't strong enough to change the substantive tax outcome, but it was strong enough to avoid a penalty on top of it. Sloppy paperwork would likely have cost Thermal both the tax and the penalty.
Where Else This Scenario Shows Up
Thermal Circuits happens to be a heating-element manufacturer, but "a customer pays for capacity, and now someone owes tax on it" is a recurring shape, not a one-off:
- Contract manufacturers and co-packers who let an anchor customer fund new tooling, a dedicated production line, or a facility expansion in exchange for exclusivity or preferred pricing.
- Franchisees whose franchisor kicks in cash toward a buildout, remodel, or equipment package tied to brand standards.
- Commercial tenants receiving a landlord's tenant improvement allowance — where the tax outcome flips entirely depending on who ends up owning the improvements (more on that below).
- Suppliers in exclusive-supply or take-or-pay arrangements, where a buyer effectively prepays for future capacity rather than making an arm's-length loan or equity investment.
It's worth contrasting Thermal's outcome with the more familiar commercial-lease version of this problem. When a landlord funds tenant improvements and retains ownership of them (the typical structure), the IRS generally treats the tenant's use of that space as a non-taxable benefit, and the landlord capitalizes and amortizes its own cost. Restaurants get an even more generous carve-out under Section 110, letting a retail-space tenant exclude a landlord's construction allowance from income outright, up to the cost of the improvements. Thermal's case looked superficially similar — a third party paying for someone else's real estate improvements — but it landed on the opposite result, precisely because the facts (insurance, taxes, occupancy certificate, risk of loss) pointed to Thermal as the owner rather than NVT. Ownership, not the source of the cash, is what determines the tax treatment.
How to Structure — and Book — a Customer-Funded Expansion Correctly
If a customer, franchisor, or strategic partner ever offers to fund a facility or capacity expansion for your business, a few practical steps can keep you from repeating Thermal's mistake:
- Decide ownership on purpose, in writing, before construction starts. Who pays the insurance and property taxes? Whose name goes on the certificate of occupancy? Who bears the risk if the building floods or burns down? Those operational details, not a label in the contract, are what a court will actually look at.
- Get tax advice before you sign, not after you're audited. Whether a payment like this is compensation or a genuine capital contribution turns on specific, fact-intensive tests. A CPA or tax attorney reviewing the agreement in advance can often restructure the deal — as a loan, an equity stake, a genuine landlord-owned improvement, or a properly negotiated up-front price adjustment — to reach the tax result both parties actually want.
- Budget for the tax hit if you're the one who ends up owning the asset. If the funds are going to be taxable income to you, set aside cash for the liability in the year you receive (or, on the accrual method, earn) the money — not the year you finish spending it on construction. A multi-year buildout can create a tax bill well before the facility is even generating extra revenue.
- Keep your books honest about what the payment actually is. Recording a large customer payment as deferred revenue only makes sense if there's a genuine future performance obligation tied to it — not simply because the cash is earmarked for construction. If it's compensation for future lower pricing, it belongs in income, and your depreciation schedule should reflect that you, not your customer, own the resulting asset.
- Match your depreciation position to your ownership position. Thermal's decision not to depreciate the improvements was consistent with (and helped support) its good-faith defense against penalties — but it also meant giving up years of depreciation deductions it was probably entitled to once the court ruled the assets were its own. Get the ownership question right early, and claim the deductions you're entitled to.
Keep Your Books Ready for Whatever the IRS Decides
Cases like this hinge on details buried in contracts, invoices, and depreciation schedules — exactly the kind of records that are easy to lose track of in a spreadsheet or a black-box accounting app. Beancount.io offers plain-text, version-controlled accounting that keeps every transaction, and the reasoning behind it, auditable years later. Get started for free and build a ledger that can stand up to scrutiny, whether it's from a customer's finance team or the IRS.