Final regulations regarding the treatment of payments to charitable entities in return for consideration were issued by the U.S. Department of the Treasury and the Internal Revenue Service (IRS) this past August 11. These regulations finalize proposed regulations issued in December 2019 and incorporate other IRS guidance.
Briefly, these regulations contain the following:
A taxpayer’s payment or transfer to or for the use of a charitable (IRC Sec. 170(c)) entity that bears a direct relationship to the taxpayer’s trade or business and that is made with a reasonable expectation of financial return commensurate with the amount of payment or transfer may constitute an allowable deduction as a trade or business expense (IRC Sec. 162), rather than as a charitable contribution (IRC Sec. 170). This applies to payments or transfers made on or after December 17, 2019.
Example: A, an individual, is a sole proprietor who manufactures musical instruments and sells them through a website. A makes a $1,000 payment to a local church for a half-page advertisement in the church’s program for a concert. In the program, the church thanks its concert supporter, including A. A reasonably expects that the advertisement will attract new customers to A’s website and will help A sell more musical instruments. A may treat the $1,000 payment as an IRC Sec. 162 trade or business expense.
A safe harbor under IRC Sec. 162 is provided for payments made by a business entity that is a C corporation or “specified pass-through entity” to or for the use of an IRC Sec. 170(c) organization if the C corporation or pass-through entity receives or expects to receive state or local tax credits in return. For purposes of these regulations, an entity is a “specified pass-through entity” if all the following are met: (i) the entity is a business entity other than a C corporation and is regarded as separate from its owners; (ii) it operates an IRC Sec. 162 trade or business; (iii) it is subject to a state or local tax incurred in carrying on its trade or business that is imposed directly on the entity; and (iv) in return for a payment to an IRC Sec. 170(c) charitable organization, it receives or expects to receive a state or local tax credit that the entity applies or expects to apply to offset a state or local tax imposed on it directly.
Such entities engaged in a trade or business may treat the portion of the payment that is equal to the amount of the credit received or expected to be received as meeting the requirements of an ordinary and necessary business expense under IRC Sec. 162. This safe harbor applies only to cash and cash equivalent payments. The safe harbor for specified pass-through entities does not apply if the credit received or expected to be received reduces a state or local income tax.
The safe harbor applies to payments made on or after December 17, 2019, though taxpayers may choose to apply it to payments made after on or after January 1, 2018.
Example: P is a limited liability company classified as a partnership for federal income tax purposes. P is engaged in a trade or business and makes a $1,000 payment to an IRC Sec. 170(c) entity. In return for the payment, P expects to receive a dollar-for-dollar state tax credit to be applied to P’s state excise tax liability incurred by P in carrying on its trade or business. Under applicable state law, the state’s excise tax is imposed at the entity level (not the owner level). P may treat the $1,000 as an IRC Sec. 162 trade or business expense.
An individual who itemizes deductions and who makes a payment to an IRC Sec. 170(c) entity in exchange for a state or local tax credit may treat as a payment of state or local tax for purposes of IRC Sec. 164 (Deduction of Taxes) the portion of such payment for which a charitable contribution deduction is or will be disallowed. This treatment is allowed in the taxable year in which the payment is made, but only to the extent that the resulting credit is applied under applicable state or local law to offset the individual’s state or local tax liability for that taxable year or the preceding taxable year.
Any unused credit permitted to be carried forward may be treated as a payment of state or local tax in the taxable year or years for which the carryover credit is applied. This safe harbor for individuals applies only to cash and cash equivalent payments. Individuals who apply this safe harbor to make deductions under IRC Sec. 164 may also deduct the same payments under any other IRC section.
Any payment treated as a state or local tax is subject to the $10,000 limitation ($5,000 for married individual filing separate return) on deductions for state and local taxes contained in IRC Sec. 164(b)(6). The regulations are not intended to permit a taxpayer to avoid such limitations.
The safe harbor applies to payments made on or after June 17, 2019, though taxpayers may choose to apply it to payments made after August 27, 2018.
Example: In year 1, Taxpayer B, an individual who itemizes deductions for federal income tax purposes, makes a payment of $7,000 to an IRC Sec. 170(c) entity. In return for the payment, B receives a dollar-for-dollar state income tax credit, which under state law may be carried forward for three taxable years. Prior to the application of the credit, B’s state tax liability for year one was $5,000; B applies $5,000 of the $7,000 credit to B’s year one state income tax liability. B treats $5,000 of the $7,000 payment as a payment of state income tax in year 1.
Prior to the application of the remaining credit, B’s state income tax liability in year two exceeds $2,000. B applies the excess credit of $2,000 to B’s year two state income tax liability. For year two, B treats the $2,000 as a payment of state income tax liability under IRC Sec. 164. To determine B’s deduction amounts in years one and two, B must apply the provisions of IRC Sec. 164, including the $10,000 cap on state and local tax deductions.
The quid pro quo principle applies regardless of whether the party providing the quid pro quo is the donee or a third party. A taxpayer will be treated as receiving goods and services in consideration for a taxpayer’s payment or transfer to a charitable IRC Sec. 170(c) entity if, at the time the taxpayer makes the payment or transfer, the taxpayer receives or expects to receive goods or services in return.
Richard Shapiro, tax director and member of EisnerAmper Financial Services Group, has more than 35 years’ experience in federal income taxation, including the taxation of financial instruments and transactions, both domestic and international. His email is [email protected]