September 10, 2018 Payments under state and local tax credit programs remain deductible as business expenses, IRS clarifies In a press release (IR-2018-178) issued September 5, 2018, the IRS announced the publication of a new "State and Local Income Tax FAQ." This FAQ clarifies that recently issued proposed regulations (REG-112176-18) concerning the availability of charitable contribution deductions for contributions to state and local tax credit programs do not affect business taxpayers' ability to claim business expense deductions for certain payments to charities or government entities for which taxpayers receive state and local tax (SALT) credits. "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," the press release notes. Background The proposed regulations, published August 23, 2018, respond to recently enacted state laws authorizing the creation of state-sponsored charities to which taxpayers could contribute and receive a credit against their personal income or property tax liabilities. These state "workarounds" are broadly viewed as an attempt to assist individual taxpayers in circumventing the $10,000 SALT itemized deduction cap recently enacted under the 2017 Tax Cuts and Jobs Act, P.L. 115-97 (TCJA). (For a detailed look at the proposed regulations, see Tax Alert 2018-1714.) The proposed regulations generally provide that if a taxpayer makes a payment to a Section 170(c) entity, and receives a state or local tax credit in return, the tax credit constitutes a return benefit, or quid pro quo, to the taxpayer and reduces the charitable contribution deduction. Although this rule may work well for individuals, for businesses the rule in the proposed regulations may be overbroad. For example, a business taxpayer who makes a business-related payment to a charity for which the taxpayer receives a state or local tax credits should have the opportunity to determine whether that payment is deductible under a provision other than Section 170. This opportunity appears to be foreclosed by the proposed regulations. Clarification for business taxpayers The new FAQ appears to address this issue by stating that the proposed regulations address the deductibility of SALT credit payments as charitable contributions under Section 170, and do not affect the availability of a business expense deduction under Section 162.1 According to the FAQ, a business taxpayer that makes a payment to a charitable or government entity generally may deduct the entire payment as an ordinary and necessary business expense under Section 162 as long as the payment is made with a business purpose. While the FAQ may adequately address the concerns of business taxpayers, the reasoning in the FAQ could result in uncertainty in some situations. Implications The root of the concern is relatively straight forward: If a business gives $10,000 to a charitable fund, and receives an $8,500 state tax credit, the proposed regulations say that the Section 170 deduction is net of the credit (or $1,500). The issue addressed in the FAQ is how a business taxpayer should treat the remaining $8,500. The FAQ concludes that a business taxpayer, making a payment to a charitable or government entity described in Section 170(c) is generally permitted to deduct the entire payment as an ordinary and necessary business expense under Section 162 if the payment is made with a business purpose. The FAQ's explanation of the Section 162 deduction criteria makes it appear that a payment to a fund could easily be a Section 162 deduction when money is donated. However, the IRS has in the past challenged taxpayers' attempts to convert charitable deductions into business expenses to avoid the income limitations imposed by Section 170 (10% of taxable income for corporations and 50% AGI limits for individuals). What is not readily apparent from the FAQ is a recognition of the historical context of the tug-of-war between the potential for a Section 162 deduction versus a Section 170 deduction under existing law (compare Revenue Ruling 72-314, 1972-1 C.B. 44, with Revenue Ruling 72-542, 1972-2 C.B. 37): -- Generally, where a taxpayer engaged in a trade or business makes a transfer of property with a reasonable expectation of financial return to himself in his trade or business, commensurate with the amount of the transfer, no deduction under Section 170 is allowable with respect to such transfer and the transfer may constitute an ordinary and necessary business expense under Section 162.2 -- Conversely, where a taxpayer engaged in a trade or business makes a voluntary contribution of property without a reasonable expectation of a financial return to him in his trade or business, the deductibility of the transfer is to be determined under Section 170 and no deduction under Section 162 will be allowable with respect to such transfer.3 Whether a particular transfer was made with a reasonable expectation of a financial return, commensurate with the amount of the transfer, is a question of fact. This subjective question of fact has been central to dozens of court cases, private letter rulings and undoubtedly audits. It would not be out of the question for would-be-donor-businesses to conclude that when they make a donation to a fund, they do not have a reasonable expectation of financial return for the businesses other than the state tax liability reduction and, therefore, are not eligible for a Section 162 deduction. Under this conclusion, they fall under the proposed Section 170 regulations and do not have certainty on the treatment of the credit. In the end, the press release and the FAQs addressed concerns of corporate taxpayers; but there are likely additional issues that taxpayers and the government need to further work through. ———————————————
——————————————— 1 All "Section" references are to the relevant section or sections of the Internal Revenue Code of 1986, as amended (the Code), or to the Treasury Regulations (Treas. Regs.) promulgated by the Treasury under the Code, unless stated otherwise. 2 For example of business deductions, see Sugarland Indus. v. Comm'r, 15 B.T.A. 1265, 1269 (1929), acq., VIII-2 C.B. 50 (1929); United States v. Jefferson Mills, Inc., 367 F.2d 392 (5th Cir. 1966); Singer Co. v. United States, 449 F.2d 413 (Ct. Cl. 1971); Marquis v. Comm'r, 49 T.C. 695 (1968), acq., 1971-2 C.B. 3; Weil Clothing Co. v. Comm'r, 13 T.C. 873 (1949), acq., 1950-1 C.B. 5; Boyd v. Comm'r, T.C. Memo 2003-286; Revenue Ruling 84-110, 1984-2 C.B. 35; Revenue Ruling 73-113, 1973-1 C.B. 65; and Revenue Ruling 63-73, 1963-1 C.B. 35. 3 On the other hand, for examples of nonbusiness/charitable deductions, see McDonnell Aircraft Corp. v. Comm'r, 16 T.C. 189 (1951), acq., 1951-2 C.B. 3; Pace v. Comm'r, T.C. Memo 2010-272; and Scheffres v. Comm'r, T.C. Memo 1969-41. | |||||||||||||
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