(Modified to add commentary on applicability date of the safe harbor)

In Revenue Procedure 2019-12 the IRS released a set of safe harbor rules that apply to C corporations and certain passthrough entities that receive a state tax credit for amounts paid to organizations qualified under §170(c).

The procedure was issued in response to proposed regulations issued in 2018 that will apply to charitable contributions made by individuals after August 27, 2018. In such cases, an individual must reduce any charitable contribution claimed by any state tax credit received for making the contribution exceeds 15% of the contribution amount.

Following the issuance of those regulations, the IRS issued a set of frequently asked questions (FAQs) that noted that, under Reg. §1.170A-1(c)(5), if a taxpayer transfers property to such an organization that bears a direct relationship to the taxpayer’s trade or business, and are made with a reasonable expectation of a financial reward commensurate with the transfer, the payment is deductible as a trade or business expense under IRC §162 and is not impacted by the proposed regulations.

The IRS notes in the procedure that there are similarities and differences for businesses conducted as C corporations and those that are conducted via a passthrough entity.

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 301.77013 of the Procedure and Administration Regulations (passthrough 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 passhrough entity’s tax liability, it is reasonable to conclude that there is a direct benefit to the passthrough entity in the form of a reduction in the state or local taxes the entity would otherwise have to pay. However, under the principles of sections 702 and 1366, the deductibility of the payment must be determined d at the level of the individual owners of the entity if the credit received or expected to be received will reduce a state or local income tax subject to the limitations in section 164(b)(6).

Because of these differences, the IRS provides two different safe harbors, one applicable to C corporations and one applicable to passthrough entities.

For a C corporation, the following safe harbor applies:

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.

Passthrough are subjected to two tests. First, the passthrough must pass a test to be a specified passthrough entity for these purposes. That test is described as follows:

An entity will be considered a specified passthrough entity described in this section 4.02 only if each of the requirements set forth in section 4.02(1) through (4) is satisfied.

(1) 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 section 301.77013;

(2) The entity operates a trade or business within the meaning of section 162;

(3) 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

(4) 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 described in section 4.02(3) of this revenue procedure other than a state or local income tax.

If passthrough passes that test, then the following safe harbor applies:

If a specified passthrough entity described in section 4.02 of this revenue procedure 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 described in section 4.02(4) of this revenue procedure that the entity applies or expects to apply to o ffset a state or local tax described in section 4.02(3) of this revenue procedure other than a state or local income tax, the specified passthrough 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.

The IRS provides the following examples of applying these safe habors. First, there is a set of examples for the C corporation safe harbor:

Example 1. 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. Under section 3 of this revenue procedure, A may treat the $1,000 payment as meeting the requirements of an ordinary and necessary business expense under section 162.

Example 2. 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. Under section 3 of this revenue procedure, 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 this revenue procedure.

The IRS then provides a pair of examples for the passthrough entity rules:

Example 1 . P is a limited liability company (LLC) classified as a partnership for federal income tax purposes under section 301.77013 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). Under section 4 of this revenue procedure, P may treat the $1,000 payment as meeting the requirements of an ordinary and necessary business expense under section 162.

Example 2. S is an S corporation engaged in a trade or business and is owned by individuals C and D. S mak es 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). Under section 4 of this revenue procedure, 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 this revenue procedure.

One key item to note is the applicability date of this Revenue Procedure’s safe harbors. Section 5.01 provides:

This revenue procedure applies to amounts described in section 3.02 of this revenue procedure that are paid on or after January 1, 2018, by a C corporation described in section 3.01 of this revenue procedure. In addition, this revenue procedure applies to amounts described in section 4.03 of this revenue procedure that are paid on or after January 1, 2018, by a specified pass-through entity described in section 4.02 of this revenue procedure.