On June 11, 2019, the Treasury Department and the Internal Revenue Service issued final regulations (TD 9864, 6/11/2019) in response to legislation enacted by a number of states and their political subdivisions aimed at allowing their residents to avoid the $10,000 annual limitation on the deductibility of state and local tax (SALT) payments brought about under newly enacted tax code Section 164(b)(6) under the Tax Cuts and Jobs Act.
Rev. Proc. 2019-12: Safe Harbor Business Deduction for Businesses Making Payments to Charity in Exchange for SALT Credits
Like the proposed regulations, the final regulations apply to charitable contributions by business taxpayers. Specifically, a business taxpayer, like an individual taxpayer, must reduce the charitable contribution deduction by the amount of any return benefit received or expected to be received as a result of a payment to an entity described in Section 170(c), which would include a state or local tax credit. Following the release of the proposed regulations on Aug. 27, 2018, the IRS received inquiries as to the implications for business taxpayers making business-related payments to charities or government entities for which the taxpayer received state or local tax credits.
The IRS then issued IR-2018-178 on Sept. 5, 2018, providing that the availability of a business deduction in such a case is not affected by the proposed regulations, stating: “The business expense deduction is available to any business taxpayer, regardless of whether it is doing business as a sole proprietor, partnership or corporation, as long as the payment qualifies as an ordinary and necessary business expense. Therefore, businesses generally can still deduct business-related payments in full as a business expense on their federal income tax return.” In the context of payments to charities and government entities for which a tax credit was provided in return, the IRS further stated that “Business taxpayers who make business-related payments to charities or government entities for which the taxpayers receive state or local tax credits can generally deduct the payments as business expenses.” On that same date, the IRS provided the following as a “frequently asked question” (“FAQ”) on state and local income tax:
“Does the proposed regulation governing contributions in exchange for state and local tax credits affect the ability of a business that makes a payment under such a program to deduct the payment as an ordinary and necessary business expense?”
“No, the proposed regulation addresses the deductibility of such payments as charitable contributions under §170. It does not affect the availability of a business expense deduction under §162. A business taxpayer making a payment to a charitable or government entity described in §170(c) is generally permitted to deduct the entire payment as an ordinary and necessary business expense under §162 if the payment is made with a business purpose. The rules permitting an ordinary and necessary business expense deduction under §162 apply to a taxpayer engaged in carrying on a trade or business regardless of the form of the business.”
After the release of the FAQ, the Treasury Department and the IRS continued to receive questions regarding the application of the proposed regulations to taxpayers engaged in trades or businesses. These questions included whether payments by these taxpayers to organizations described in Section 170(c) in return for state income, property, and other business tax credits would bear a direct relationship to the taxpayer’s trade or business, such that these payments would be considered ordinary and necessary business expenses of carrying on such trade or business under Section 162(a) to the extent of the credit received or expected. In response, on Dec. 28, 2018, the IRS issued safe harbor provisions under Revenue Procedure 2019-12, discussed in further detail below, dealing with C corporations and pass-through entities, where under the “Background” section of Rev. Proc., 2019-12, the IRS stated as follows:
“To the extent a C corporation receives or expects to receive a state or local tax credit in return for a payment to an organization described in section 170(c), it is reasonable to conclude that there is a direct benefit to the C corporation’s business in the form of a reduction in the state or local taxes the C corporation would otherwise have to pay and, therefore, to the extent of the amount of the credit received or expected to be received, there is a reasonable expectation of financial return to the C corporation commensurate with the amount of the transfer.”
“Similarly, in the case of a business entity other than a C corporation that is regarded as separate from its owner for all federal tax purposes under section 301.7701-3 of the Procedure and Administration Regulations (pass-through entity) and that is operating a trade or business within the meaning of section 162, to the extent the credit received in return for such a payment can reduce the pass-through entity’s tax liability, it is reasonable to conclude that there is a direct benefit to the pass-through entity in the form of a reduction in the state or local taxes the entity would otherwise have to pay.”
In Rev. Proc. 2019-12, for amounts paid after Jan. 1, 2018, the IRS has provided certain safe harbors under Section 162 for certain payments made by a C corporation or a “specified pass-through entity” to or for the use of a charitable or governmental entity described in Section170(c) even if the C corporation or specified pass-through entity receives or expects to receive a state or local tax credit in return for such payment. For a specified pass-through entity to be eligible for the safe harbor, however, the entity must itself be subject to a state or local tax incurred in carry on its trade or business and the credit must offset a state or local tax other than state or local income tax. The safe harbors are as follows:
C Corporation safe harbor. If a C corporation makes a payment to or for the use of an organization described in Section 170(c) and receives or expects to receive a tax credit that reduces a state or local tax imposed on the C corporation in return for such payment, the C corporation may treat such payment as meeting the requirements of an ordinary and necessary business expense for purposes of Section 162(a) to the extent of the credit received or expected to be received. Examples provided under Rev. Proc. 2019-12:
- A, a C corporation engaged in a trade or business, makes a payment of $1,000 to an organization described in Section 170(c). In return for the payment, A receives or expects to receive a dollar-for-dollar state tax credit to be applied to A’s state corporate income tax liability. A may treat the $1,000 payment as meeting the requirements of an ordinary and necessary business expense under Section 162.
- B, a C corporation engaged in a trade or business, makes a payment of $1,000 to an organization described in Section 170(c). In return for the payment, B receives or expects to receive a tax credit equal to 80 percent of the amount of this payment ($800) to be applied to B’s local real property tax liability. B may treat $800 as meeting the requirements of an ordinary and necessary business expense under Section 162. The treatment of the remaining $200 will depend upon the facts and circumstances and is not affected by Rev. Proc. 2019-12.
Specified pass-through entity safe harbor. If a “specified pass-through entity” makes a payment to or for the use of an organization described in Section 170(c) and 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 other than a state or local income tax, the specified pass-through entity may treat such payment as meeting the requirements of an ordinary and necessary business expense for purposes of Section 162(a) to the extent of the credit received or expected to be received. An entity will be considered a specified pass-through entity only if each of the following requirements is satisfied.
- The entity is a business entity other than a C corporation that is regarded for all federal income tax purposes as separate from its owners under Reg. 301.7701-3, that is, it is not a “disregarded entity” that is treated for federal income tax purposes as one and the same as its owner;
- The entity operates a trade or business within the meaning of Section 162;
- The entity is subject to a state or local tax incurred in carrying on its trade or business that is imposed directly on the entity; and
- In return for a payment to an organization described in Section 170(c), the entity 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 other than a state or local income tax.
Examples provided under Rev. Proc. 2019-12:
- P is a limited liability company classified as a partnership for federal income tax purposes under Reg. 301.7701-3 and is owned by individuals A and B. P is engaged in a trade or business within the meaning of Section 162 and makes a payment of $1,000 to an organization described in Section 170(c). In return for the payment, P receives or 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 payment as meeting the requirements of an ordinary and necessary business expense under Section 162.
- S is an S corporation engaged in a trade or business and is owned by individuals C and D. S makes a payment of $1,000 to an organization described in Section 170(c). In return for the payment, S receives or expects to receive a state tax credit equal to 80 percent of the amount of this payment ($800) to be applied to S’s local real property tax liability incurred by S in carrying on its trade or business. Under applicable state and local law, the real property tax is imposed at the entity level (not the owner level). S may treat $800 of the payment as meeting the requirements of an ordinary and necessary business expense under Section 162. The treatment of the remaining $200 will depend upon the facts and circumstances and is not affected by Rev. Proc. 2019-12.
Rev. Proc. 2019-12 was issued prior to the final regulations issued on June 11, 2019. The preamble to the final regulations specifically notes that Rev. Proc. 2019-12 was issued in response to question “regarding the application of section 162 and 164 to business entities that make payment to section170(c) entities and that received or expect to receive state or local tax credits in return for such payments.” The preamble further states that “Neither the final regulations nor the safe harbors in the revenue procedure otherwise affect the availability of a business expense deduction under section 162 for payments that are ordinary and necessary expenses incurred in carrying on a trade or business. The Treasury Department and the IRS will continue to study comments involving the effect of the final regulation on various business entities and will provide additional guidance as needed.”
Interestingly, the safe harbor provision of Rev. Proc. 2019-12 is consistent with Notice 2019-12, discussed above, under which an individual may treat as a payment of state or local tax for purposes of Section 164 the portion of such payment for which a charitable contribution deduction under Section 170 is or will be disallowed under final regulations as a result of the receipt of a tax credit provided in return for the payment. Given that state and local taxes incurred in the context of a trade or business are deductible under Section 162, it would follow, based upon the treatment under Notice 2019-12 of the tax credit as a tax payment, that the amount of the tax credit received by a business as a result of a payment to an entity described in Section 170(c) would be deductible under Section 162.
Standard Generally Applied for Determining Whether a Payment to Charity Constitutes a Business Deduction
If a taxpayer transfers money or property to a charity in connection with a trade or business and the transfer bears a directly relationship to the trade or business and there is a reasonable expectation of a financial return commensurate with the amount transferred, a charitable contribution deduction will not be allowed. The transfer may, however, be deductible as a business expense under Section 162(a), which permits a taxpayer to deduct “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” The taxpayer does not have a choice in determining whether a payment is deductible as a charitable contribution or an ordinary or necessary business expense. Instead, the tax code requires that if the amount transferred is, in fact, a charitable gift, it cannot be deducted as a business expense and if the amount transferred is a business expense, it cannot be deducted as a charitable contribution. In Revenue Ruling 72-314, the IRS set forth the following standard to determine whether payments to a charitable organization constitute a charitable contribution under Section 170 or a trade or business expense under Section 162:
“Whether payments … are ‘contributions or gifts,’ within the meaning of section 170 of the Code, or are deductible as ordinary and necessary business expenses under section 162 of the Code depends upon whether such payments are completely gratuitous or whether they bear a direct relationship to the taxpayer’s business and are made with a reasonable expectation of a financial return commensurate with the amount of the payment. [Where] the payments in question are related to the taxpayer’s business and could reasonably be expected to commensurately further such business financially, such payments are deductible as ordinary business expenses under section 162(a) of the Code.”
The taxpayer in Rev. Rul. 72-314, a brokerage company, paid an amount equal to 6% of all brokerage commissions to a charitable organization whose purpose was to reduce neighborhood tensions and combat community deterioration in the neighborhood in which the taxpayer’s office was located. The payments were made in order to promote business in a particular neighborhood in which its office was located and to compete successfully with other brokerage firms located in more established financial neighborhoods of the city. The taxpayer emphasized in its advertisements to customers and potential customers that the payments made to the charitable organization would enable the customers to benefit the organization and, therefore, the community, without incurring additional expenses. The taxpayer reasonably expected to derive new business and retain the business of existing customers by implementing this program. The IRS ruled that because the payments related to the taxpayer’s business and could reasonably be expected to commensurately further the business financially, the payments constituted ordinary and necessary business expenses under Section 162, notwithstanding that they were made to a charity.
In Boyd v. Commissioner, the taxpayer, an attorney, was unable to substantiate certain payments to charitable organizations in accordance with Section 170, and therefore, such payments could not be deducted as charitable contributions. He argued, however, that while a charitable deduction may not be available under Section 170, the amounts paid to charity should nonetheless be deductible as a trade or business expense under Section 162 (on Schedule C, not Schedule A, of the taxpayer’s Form 1040) because he made the payments for business purposes “in my capacity as an attorney.” In its analysis, the court noted that Reg. 1.162-15(b) specifically permits contributions to be treated as trade or business expenses if the contributions “bear a direct relationship to the taxpayer’s business and are made with a reasonable expectation of a financial return commensurate with the amount of the donation may constitute allowable deductions as business expenses.” The court found that although the taxpayer did not substantiate the charitable contributions with written documentation as required under Section 170, it was satisfied that the taxpayer did make some payments qualifying as deductible trade or business expenses. Under the court’s discretionary authority pursuant to Cohan v. Commissioner, the taxpayer was allowed a deduction as a trade or business expense. See also Marquis v. Commissioner, where a taxpayer’s payments to clients that were charitable entities furthered her travel agency business and were therefore business expenses under Section 162, not charitable contributions under Section 170.
Where a business taxpayer makes a payment to charity, the determination of whether the payment is deductible as a charitable contribution or a business expense has historically been a question of fact. If the payment is made with the reasonable expectation of commensurately furthering the business financially, such as by obtaining new business or customers, the payment is deductible as a business expense under Section 162. Where, however, the payment is made without the expectation such a financial return to the trade or business, the deductibility of the payment is determined under Section 170. Absent the application of Rev. Proc. 2019-12, a payment to charity that is made without any expectation of any financial return to the business, other than a credit for state or local taxes, may not, under the requisite facts and circumstances analysis, be considered a business expense under Section 162. And, because a state and local tax credit is considered a quid pro quo under the final regulations, no charitable deduction under Section 170 may be available in such a case. The safe harbor provisions under Rev. Proc. 2019-12, however, deem the state and local credits received in return for a payment to charity by a qualified business as a direct benefit to the business and, therefore, treat the payment to the charity as a business expense to the extent of the credit received by the business. The deductible of any amount paid by a business in excess of the credit received would be determined under the facts and circumstances analysis as applied to such excess amount.
Conclusion
Consistent with Notice 2018-54 and the proposed regulations previously issued by the IRS, and nullifying the $10,000 annual SALT limitation legislative workaround attempts by a number of states and their political subdivisions, the final regulations provide that a taxpayer who makes payments or transfers property to an entity eligible to receive tax deductible contributions must reduce their charitable deduction by the amount of any state or local tax credit the taxpayer receives or expects to receive. The final regulations generally retain the amendments set forth in the proposed regulations, with certain clarifying and technical changes. Notwithstanding the indication in Notice 2018-54 that the regulations issued in this area would be limited to charities “controlled by state and local government” under the recent workaround legislation, the final regulations, like the proposed regulations, are broad in their application, providing that the amount of a charitable income tax deduction under Section 170(a) for a contribution to any entity must be reduced by the amount of any state or local tax credit the taxpayer receives or expects to receive in return.
While the final regulations clearly target recently enacted state and local legislative efforts seeking to circumvent the SALT limitation, their application also extends to longstanding programs across the country in which state and local tax credits have been provided for donations to certain community organizations and private schools where, with the apparent blessing of the IRS, taxpayers have for years been claiming charitable contribution deductions notwithstanding the tax credits provided in return. Therefore, although the impetus for their issuance was recent legislative efforts to avoid the SALT cap, the purview of the final regulations extends to preexisting tax credit programs aimed at encouraging donations to various charitable and educational institutions that have come to rely on such programs for support and that now may be in jeopardy because of the elimination of the charitable deduction that historically has been available in this context.
Interestingly, businesses fare better than individuals in connection with payments to charity in return for which tax credits are provided. While the final regulations apply to charitable contributions by businesses so as to reduce the amount of the otherwise available charitable deduction by the amount of the tax credit received in return, under Rev. Proc. 2019-12 issued on the same date as the final regulations, the IRS has provided safe harbors to treat the amount of the tax credit as an ordinary and necessary business expense under Section 162, not subject to the SALT limitation under Section 164(b)(6), where the payment is made by a C corporation or a “specified pass-through entity” to or for the use of an entity described in Section 170(c) in return for which the C corporation or specified pass-through entity receives or expects to receive a state or local tax credit.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Richard L. Fox is a shareholder in the Philadelphia office of Buchanan, Ingersoll & Rooney, PC.