In the case of Maines v. Commissioner, 144 TC No. 8, the Tax Court had to consider the federal tax treatment of various tax credits provided by the state of New York.

The credits in question in this case were:

QEZE Real Property Tax Credit – a credit limited to the amount of past real estate taxes paid. However, while the credit is based on real estate taxes, it is a credit against New York income tax liabilities with any remaining unused credit treated as an overpayment of New York taxes
EZ Investment Credit – a credit labeled by the state of New York as a repayment of past taxes, but for which no limits were imposed based on taxes actually paid. Again it is a credit against income taxes. If the taxpayer has credit in excess of the tax paid for a year the taxpayer may either carry it forward or opt for a refund of 50% of the balance remaining.
EZ Wage Credit – another credit that, like the EZ Investment Credit, is labeled by the state of New York as a repayment of past taxes but has no limit based on taxes previously paid. Credits not used against income taxes may be either carried forward or partially refunded.

The credits all are part of the “Empire Zones Program” intended to stimulate investment and development in various impoverished areas in New York, hopefully leading to the creation of jobs in these areas. The credits are referred to generally as “EZ” credits.

The taxpayers had invested as the state wished and, due to various credits, had no state income tax liabilities at all for the credits to offset in 2006 and 2007, while in 2005 those other credits wiped out ½ of their state liability with only a portion of the “EZ credits” needed to offset the tax. Thus the taxpayers received large refunds in those years.

Now the question arose—do some or all of these payments represent taxable income? And the key issue in question becomes the “tax benefit” rule, something we normally run into in state tax refund cases.

The taxpayers in this case point out that they had never claimed a deduction for state income taxes, so this refund would not trigger tax under the tax benefit rule.

They argue:

The Maineses stipulated that they took no deduction on their federal income-tax returns for the years at issue for state income tax paid in the preceding year. They argue that their credits under the EZ Program are just like excess state income-tax withholding--they point out that the credits that New York gave them are defined by state law to be "overpayments" of state income tax. They argue that they are like our nonitemizing hypothetical taxpayer, which means that they got a big state income-tax refund that they don't have to include in their federal taxable income.

The court agreed that New York called these refunds “overpayments” of New York income tax. But, the Court notes, “the key question in this case becomes whether a federal court applying federal law has to go along with New York's definition.”

Not surprisingly the taxpayers argue that, yes, the federal courts have to respect the label New York applied to these payments. Federal taxes are imposed after respecting the property rules of the underlying state law.

However, the IRS disagrees with that view. The Court notes that while the IRS

...agrees that New York law labels the credits as "income tax credits," and excesses or surpluses as "overpayments" of state income tax for state-tax purposes. But is a state's legal label for a state-created right binding on the federal government? Here begins the disagreement. The Maineses contend that New York's tax-law label of these excess EZ Credits as overpayments is a legal interest that binds the Commissioner and us when we analyze their taxability under federal law. The Commissioner warns that if this were true, a state could undermine federal tax law simply by including certain descriptive language in its statute. To use Lincoln's famous example, if New York called a tail a leg, we'd have to conclude that a dog has five legs in New York as a matter of federal law. See George W. Julian, "Lincoln and the Proclamation of Emancipation," in Reminiscences of Abraham Lincoln by Distinguished Men of His Time (Allen Thorndike Rice, ed., Harper & Bros. Publishers 1909), 227, 242 (1885), available at https://archive.org/details/cu31924012928937.

The Tax Court finds the IRS argument more compelling in this case—New York cannot change reality by simply attaching a label to something that clearly is not what they claim it to be—in this case an overpayment of state income taxes.

The Tax Court notes:

The Maineses have a legal interest in the giant credits that New York law entitles them to. Those credits were paid to the Maineses, and nothing we say undermines New York's decision to make them. But federal tax law has its own say in how to characterize those payments under the Code. Under New York law, to qualify for the EZ Investment Credit, a taxpayer must own a business that places in service qualified property in a designated Empire Zone. To qualify for the EZ Wage Credit, a taxpayer must own a business that has full-time targeted employees who receive qualified EZ wages. Neither credit is, in substance, a refund of previously paid state taxes deducted under federal law. They are just transfers from New York to the taxpayer--subsidies essentially.

The Court finds, therefore that the EZ Investment Credit and EZ Wage Credits, to the extent they exceed the state income taxes for the year for the taxpayer, represent plain vanilla income under IRC §61(a).

The Court also finds that it’s not relevant whether the taxpayer elects to receive the refund or carry the credit forward—any amount they could have received as a refund will be deemed taxable under the doctrine of constructive receipt.

The Court also distinguished these payments form those excludable under the general-welfare exception to income inclusion. The Court notes:

To qualify for the general-welfare exclusion, a payment must (1) be made from government funds, (2) promote the general welfare (generally based on need), and (3) not be compensation for services. Id. Grants from welfare programs that don't require recipients to show need have not qualified for the general-welfare exclusion. See Bailey v. Commissioner, 88 T.C. 1293, 1300 (1987) (denying the exclusion for payments from a facade grant program when the taxpayer only had to show ownership and building code compliance to qualify).

Critics of programs like New York's might call them "corporate welfare." But that's just a metaphor--the credits that New York gave to the Maineses were not conditioned on their showing need, which means they do not qualify for exclusion from taxable income under the general-welfare exception. See also, e.g., Rev. Rul. 2005-46 (holding that state grants for expenses incurred by businesses that agree to operate in disaster areas are not excludable under the general-welfare exclusion)

However the QEZE Property Tax Credit is different—while it may be used to offset income taxes, it is truly limited to real estate taxes previously paid. In this case, though, the Court found that the property taxes in question had been previously deducted and thus the refundable portion of the credit amounted to taxable income under the tax benefit rule.