Online tax discussion groups, many of which are sponsored by state CPA societies for their members, offer useful places to discuss tax issues and become aware of what is going on in taxes.  It was when participating in such a group discussion that I became aware of a theory being proposed to allow working around the state and local tax deduction cap based on the proposed regulations[1] issued by the IRS in December regarding payments to charitable organizations not treated as charitable contributions under Proposed Reg. §1.162-15.

Arizona Credit at the Center of the Issue

The particular credit that gave rise to this discussion is unique to the state of Arizona, though if the workaround works other states clearly could establish a similar structure.  The key provision is found at Arizona Revised Statutes §43-1089.04, which allows an S corporation making a private tuition organization donation described at ARS §43-1183.F or §43-1184.F to pass that credit against state income taxes to its shareholders.

The credit is limited only in the aggregate—it is awarded to corporations on a “first-come, first-served” basis until the total allocated to the fund for a year is exhausted.

The claim being made is that such contributions could be treated as trade or business expenses in at least some circumstances on the S return.  The theory goes that under the rules of Proposed Reg. §1.162-15, this amount would be deducted in full in arriving at the S corporation’s non-separately stated income that flows to Schedule E, despite the shareholder receiving a tax credit against his/her Arizona income taxes in an amount exactly equal to what was paid.

My take—if we take the language of an example that isn’t replicated in the main text of the regulation as green-lighting the option, then it is possible.  But the practical hurdle of meeting the requirement to show a reasonable expectation of income in excess of the contribution may create an insurmountable hurdle in many cases.

The Proposed Regulation

Most observers believed that the regulations first proposed in August of 2018 had closed down any opportunity to use this to work around the $10,000 state and local tax deduction cap on Schedule A of Form 1040.  And that the door was firmly slammed shut by Revenue Procedure 2019-12 that, while providing a safe harbor for claiming payments to a charity as a deduction even if a credit was received in a business context, it specifically did not allow such a credit if the entity was a passthrough and the tax in question was an income tax.

Apparently, donors felt the door was shut as well—while the fund had received the maximum allotted amount of contributions within minutes of accepting applications in the summer of 2018, the same was not true when applications began to be accepted in 2019.

But now the idea has been floated that Proposed Reg. §1.162-15, issued in December of 2019, would, if made final, allow the program to spring back to life.

Those pushing this theory would point to revised Proposed Reg. §1.162-15(a)(1) which reads:

(a) Payments and transfers to entities described in section 170(c) — (1) In general. A payment or transfer to or for the use of an entity described in section 170(c) 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 the payment or transfer may constitute an allowable deduction as a trade or business expense rather than a charitable contribution deduction under section 170. For payments or transfers in excess of the amount deductible under section 162(a), see §1.170A-1(h).

And the regulation gives the following example of such an expenditure by a passthrough:

Example 2. Proposed Reg. §1.162-13(a)(2)

P, a partnership, operates a chain of supermarkets, some of which are located in State N. P operates a promotional program in which it sets aside the proceeds from one percent of its sales each year, which it pays to one or more charities described in section 170(c). The funds are earmarked for use in projects that improve conditions in State N. P makes the final determination on which charities receive payments. P advertises the program. P reasonably believes the program will generate a significant degree of name recognition and goodwill in the communities where it operates and thereby increase its revenue. As part of the program, P makes a $1,000 payment to a charity described in section 170(c). P may treat the $1,000 payment as an expense of carrying on a trade or business under section 162. This result is unchanged if, under State N's tax credit program, P expects to receive a $1,000 income tax credit on account of P's payment, and under State N law, the credit can be passed through to P's partners.

That last sentence, adding a “clarification” to the regulation, seems to strongly imply there would be a deduction, without reduction for the benefit received, for the payment made by the partnership once the bar is cleared to show a relationship to the business and an expected benefit in excess of the contribution made.

But Don’t Use the Safe Harbor

But now we hit a bump in the road.  The proposed regulation provides for the following safe harbor that would solve the problem of having to determine if the payment was a trade or business expense.  Proposed Reg. §1.162-15(a)(3)(i) provides:

(i) Safe harbor for C corporations.

If a C corporation makes a payment to or for the use of an entity described in section 170(c) and receives or expects to receive in return a state or local tax credit that reduces a state or local tax imposed on the C corporation, 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 amount of the credit received or expected to be received.

That safe harbor solves the not inconsequential problem of determining if the payment is a trade or business expense under §162 under the general rule of Reg. §1.162-15(a)(1).  If a state tax credit is received for the payment it will be treated as a business expense.  But the rule only applies to C corporations.

A second safe-harbor applies for certain passthroughs.  But we quickly discover that one is not going to help us because it specifically excludes credits against income taxes, despite the last line in the example cited above.  Proposed Reg. §1.162-15(a)(3)(ii) provides:

(ii) Safe harbor for specified passthrough entities — (A) Definition of specified passthrough entity. For purposes of this paragraph (a)(3)(ii), an entity is a specified passthrough entity if each of the following requirements is satisfied —

(1) The entity is a business entity other than a C corporation and is regarded for all Federal income tax purposes as separate from its owners under §301.7701-3 of this chapter;

(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 entity described in section 170(c), the entity described in paragraph (a)(3)(ii)(A)(1) of this section receives or expects to receive a state or local tax credit that this entity applies or expects to apply to offset a state or local tax described in paragraph (a)(3)(ii)(A)(3) of this section.

(B) Safe harbor. Except as provided in paragraph (a)(3)(ii)(C) of this section, if a specified passthrough entity makes a payment to or for the use of an entity described in section 170(c), and receives or expects to receive in return a state or local tax credit that reduces a state or local tax described in paragraph (a)(3)(ii)(A)(3) of this section, 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 amount of credit received or expected to be received.

(C) Exception. The safe harbor described in this paragraph (a)(3)(ii) does not apply if the credit received or expected to be received reduces a state or local income tax.

In this case, the IRS removes the safe harbor protection for the payment if the tax in question is an income tax.

So, while the IRS gives hope with the example in Proposed Reg. §1.162-15(a)(1), the agency turns around and indicates that, unlike Example 1, Example 2’s taxpayer would not be able to make use of the safe harbor.

The §162 Deduction Standard for Payments to Charities

We are back to Proposed Reg. §1.162-15(a)(1) to determine if we have a trade or business expense for the payment to the charity.  The language found there is mainly drawn from current Reg. §1.170A-1(c)(5), which will reference the new Proposed Reg. $1.162-15(a)(1) if the regulations are made final.

That provision requires the payment meet two criteria to become a Proposed Reg. §1.162-15(a)(1) expenditure:

• The expenditure must bear a direct relationship to the taxpayer’s trade or business and

• The expenditure is made with a reasonable expectation of financial return commensurate with the amount of the payment or transfer.[2]

Since this language is identical to the language that had already existed in the regulations, what does the case law tell us about how the courts have looked at that provision?

Before the Tax Reform Act of 1986, advisers ran into this issue quite often.  Many small businesses were organized as C corporations at the time and such entities generally had little taxable income.  Officer salaries absorbed most of the funds available once all bills were paid.  Corporations have a limit on charitable contribution deductions that is very low—no more than 10% of taxable income. 

Thus, for a small C corporation, there was little or no taxable income, so little or no amount of allowed charitable contribution.  In that environment, taxpayers and advisers looked to reclassify an item as something other than a charitable contribution.

A Tax Adviser article from August of 1995[3], archived at The Free Library, lists a series of citations to rulings and cases where a business link was found.  In each case the two tests cited above were met.

The listed cases and rulings from that article, along with the article’s summary of each, are reproduced baelow:

• Bargain sales of sewing machines by a sewing machine manufacturer to churches, schools and other charitable entities, in order to encourage training in the use of sewing machines and enlarge its future market (Singer Co., Ct. Cl., 1971).

• Payments by a travel agency to charitable organization clients when the payments were based on the amount, character and profitability of the business received and expected to be received (Marquis, 49 TC 695 (1968), acq. 1971-2 CB 3).

• Payments by a corporation to a charitable organization for cooperation and the use of its name in connection with the corporation's advertising program. Under the arrangement, the corporation paid the charity a specified amount on each unit of the corporation's product for which the purchaser mailed a label to the charity (Rev. Rul. 63-73).

• Payments made by the operator of parimutuel racetracks to local charities of profits earned on certain charity days, when the charity days were run to facilitate a favorable vote from the citizens in the area to enable the taxpayer to retain its racing license (Rev. Rul. 77-124; cf. Rev. Rul. 72-542).

• Payments by a stock brokerage business to a charitable organization equal to 6% of brokerage commissions received from the charitable organization, when the taxpayer advertised that it was making the payments to enable the charitable organization to reduce neighborhood tensions and combat community deterioration in the area in which the taxpayer's office was located. The taxpayer believed this advertised policy would promote new business and enable it to retain existing business (Rev. Rul. 72-314).

• Payments by a retail business in a resort city to a governmental oil pollution control fund used for research, beautification and advertising, in order to help recover tourist business lost due to oil pollution (Rev. Rul. 73-113).

• Payments by an employer corporation to a tax-exempt union educational and cultural charitable trust, when the payments were required pursuant to a collective bargaining agreement (Rev. Rul. 74-51).

• Contributions to a tax-exempt dance company in financial difficulty, when the taxpayer derived substantial income from performing services for the dance company (Letter Ruling 9045015).

• Payments by a supermarket business of 1% of its sales to various civic organizations, churches, government entities and charities located in the communities where stores were located, pursuant to a program of advertising the donation program in newspapers and on radio and television. The charities were required to agree to the use of the charity's name in connection with the advertising (Letter Ruling 9309006).

One item of interest to note in the above list is that Rev. Rul. 77-124 was issued to distinguish the situation found in Rev. Rul. 72-542.  In that ruling, the facts were as follows:

The taxpayer is a corporation engaged in the business of operating a pari-mutuel race track. The corporation is licensed, regulated, and supervised by the Racing Commission of the state where the track is operated. The corporation is licensed to operate the track is a predetermined number of days, but elected under regulations of the Racing Commission to operate the track one additional day only for purposes of charity. Under such regulations, the corporation's election requires it to contribute all of the gross amount of that portion of gross receipts of all pari-mutuel wagers retained by it (i.e., a certain percentage of the pari-mutuel wagers less the state's tax thereon) from such charity day racing, to a charitable corporation, trust, fund or foundation. A foundation was formed by the corporation that qualifies as an organization described in section 170(c)(2) of the Internal Revenue Code of 1954. The taxpayer's portion of the pari-mutuel wagers from charity day racing was distributed to the foundation. There was no expectation of an economic return commensurate with the amount distributed.

There is no written or verbal lease between the taxpayer and the foundation concerning the use of the track facilities during charity day, and the provisions of the general insurance policy issued to the taxpayer provides public liability coverage on charity day. Advertising and promotional activities for charity day are provided by the taxpayer.

The ruling first holds that the amounts received are income to the business under IRC §61.

In the instant case, the taxpayer and not the foundation is the promoter of charity day since only the taxpayer is licensed by the state to operate a pari-mutuel race track. Under the state's regulations, the taxpayer could operate the track an additional day over the predetermined number of days allotted to it only if the taxpayer contributes its portion of the pari-mutuel wagers to a charitable organization. The taxpayer is not an agent for the foundation and is in effect assigning to the foundation earnings derived by it from the operation of the charity day racing.

Accordingly, that portion of gross receipts of all pari-mutuel wagers retained by the taxpayer on charity day racing and subsequently distributed to the charitable foundation is income to the taxpayer within the meaning of section 61 of the Code.

However, the real question is what happens to the payment to the charity.  In this case the IRS finds the payment does not meet the two tests cited earlier.

If a taxpayer makes a transfer of property to a charitable organization with a reasonable expectation of an economic return to himself in his trade or business, commensurate with the amount of the transfer, no deduction under section 170 of the Code is allowable with respect to such transfer and the transfer may constitute an ordinary and necessary business expense under section 162 of the Code. See Revenue Ruling 72-314, C.B. 1972-1, 44: Conversely, if a taxpayer makes a voluntary transfer of property to a charitable organization without expectation of a commensurate economic return to him in his trade or business, the deductibility of the transfer is determined under section 170 of the Code, and no deduction under section 162 of the Code is allowable with respect to such transfer.

Whether a particular transfer was made with a reasonable expectation of an economic return commensurate with the amount of the transfer is a question of fact. In the instant case, the taxpayer did not expect a commensurate economic return from the amount distributed to the foundation.

Accordingly, the amount of pari-mutuel wagers retained by the taxpayer on charity day racing and distributed to the charitable foundation is not deductible as an ordinary and necessary business expense by the taxpayer under section 162(a) of the Code. However, such amount is deductible as a charitable contribution under section 170 of the Code, subject to the conditions and limitations contained in section 170 of the Code.

The preamble to the proposed regulations specifically refers to the Marquis case in discussing when a charitable contribution is a business expense.  It’s useful to refer back to that case and note just how integral the payments to charities were to her travel agency business.  Her business came primarily from charitable organizations.  As the Court noted in finding that her payments were business expenses and not contributions:

Petitioner’s charitable clients were numerous (some 30 in all) and bookings in connection with their organizationally sponsored trips represented a very substantial part of business (57 percent of her total billings). She had direct and continuous business dealings with them. Moreover, she contributed to the charities with which she was otherwise identified. On a recurring basis, she made payments of the type in question (including payments during the taxable years involved herein), not only in the expectation that she would continue to obtain business from the recipient, but because she could well have lost such business if she had stopped. The payments were directly keyed to the amount, character, and profitability of the business which petitioner obtained and expected to obtain from the charitable clients. Petitioner had no other feasible means of reaching these clients through normal advertising channels. Cf. Hartless Linen Service Co., 32 T.C. 1026, 1030 (1959). In short, petitioner’s charitable clients represented a substantial, continuing, integral part of her business. They were in every sense petitioner’s bread and butter.[4]

Another issue that is not clear from the regulation, is whether the determination of whether there is a sufficient benefit is made before or after taking into account the economic benefit from the tax credit.

The example might suggest it is tested before the credit, since the example comes to its conclusion based on a payment without telling us if there was or was not a credit—thus, the benefit exceeded the payment without any “subsidy” in play.  The example only then tells us the result does not change if the passthrough gets a 100% credit for the expenditure.

Obviously, if the taxpayer could offset the payment with the 100% credit before checking for a business benefit, even the most minor of possible benefits would be enough to meet the test.  While this is a result we might like, it doesn’t seem likely the IRS is going to agree with this view.  Certainly, it seems odd that they would have shut down the safe harbor option only to make it this easy to qualify—presumably the intent was to create a higher standard for income tax credit payments to charitable organizations.

It is possible some clarification may come when final regulations are issued regarding whether or not the tax benefit is to be considered in making the determination whether the payment qualifies as a §162 expense.

Limitation on the §162 Deduction

The last sentence of Proposed Reg. §1.162-15(a)(1) provides:

For payments or transfers in excess of the amount deductible under section 162(a), see §1.170A-1(h).

As modified by these proposed regulations, Reg. §1.170A-1(h)(2)(i) would limit the deduction as follows:

The charitable contribution deduction under section 170(a) for a payment a taxpayer makes partly in consideration for goods or services may not exceed the excess of -

(A) The amount of any cash paid and the fair market value of any property (other than cash) transferred by the taxpayer to an organization described in section 170(c); over

(B) The fair market value of the goods or services received or expected to be received in return.[5]

The only change made by the proposed regulations was to add “or expected to be received” to (B) above.

Thus, a taxpayer will appear to need to quantify the goods or services expected to be received in order to determine the proper §162 business expense.  The remaining amount would be a charitable contribution per the regulations.

Effective Date

The proposed regulations provide the following regarding taxpayers’ abilities to apply these rules prior to the publication of final regulations:

The proposed amendments contained in §§1.162-15(a)(1) and (2) and 1.170A-1(c)(5), regarding the application of section 162 to taxpayers that make payments or transfers to entities described in section 170(c), are proposed to apply to payments or transfers on or after December 17, 2019. However, a taxpayer may rely on these proposed regulations for payments and transfers made on or after January 1, 2018 and before the date regulations finalizing these proposed regulations are published in the Federal Register.[6]

Note that the key “Example 2” resides in Proposed Reg. §1.162-15(a)(2), and thus taxpayers could apply it retroactively to 2018 transactions.

With regard to the safe harbor rules, the preamble provides:

The proposed amendment contained in §1.162-15(a)(3), regarding safe harbors for C corporations and specified passthrough entities making payments to or for the use of section 170(c) entities in exchange for state or local tax credits, is proposed to apply to payments on or after December 17, 2019. However, prior to this date, a taxpayer may continue to apply Rev. Proc. 2019-12, which applies to payments made on or after January 1, 2018.[7]

Other Challenges

Advisers assumed that, based on what was said in Revenue Procedure 2019-12 about income tax based credits not qualifying for the passthrough safe harbor and no discussion of any other special rules for passthroughs, that such payments had to be reduced by the available credit.  However, the regulations and procedure did not ever say that a reduction was mandatory.

Now we have to take care not to go the other way.  Certainly, the example implies that a full deduction is available, but it never explicitly says that the deduction does not have to be reduced by value received, much in the same way as would be true if an expense incurred by the taxpayer was reimbursed by a customer or client.  It certainly seems out of character given what was written—but, then, the same could be said about Example 2 appearing to be out of character with the guidance given at the beginning of 2019.

So, if we want to limit ourselves solely to what the IRS has explicitly said in the regulations, what are the exposures if a taxpayer attempts to claim a full deduction on the passthrough and a tax credit individually?

• As was mentioned just before, the IRS could argue that the credit represents a “reimbursement” so that while the expense may be a §162 deduction, the tax credit benefit represents business income the shareholder would have to report to offset that deduction. 

• There’s a potential, though minimal, risk that the IRS could argue that an example should not be treated as binding except to the extent it clearly reflects an item found in the text of the regulation.  The text of the regulation does not indicate that there is no offset.  However, Courts have generally viewed examples in regulations as part of the regulation and would likely not be apt to agree to turn a blind eye to the clear statement in the example.

Advising Clients

Advisors face some interesting challenges in dealing with clients under these proposed regulations.

First there’s the issue of 2018 returns.  If a taxpayer made a contribution via a flow through organization in 2018 and did not claim the deduction, an analysis must be made to determine if the taxpayer can meet the standards to claim a §162 deduction.  That will include outlining the benefits the taxpayer expected to receive from the payment and quantifying the expected benefits.

If it appears an additional deduction is possible, the taxpayer will need to consider the filing of an amended return.  If the entity in question is a partnership (such as the one in Example 2) where the benefit was not claimed, the adviser must note if the partnership filed an election to opt out of the centralized partnership audit regime for 2018.  If not, then the special rules for handling claims for such partnerships would need to be followed, effectively resulting in tax credits that would be claimed against taxes paid for the year the adjustment is transmitted to the partners.

If a taxpayer actually made a potentially qualifying contribution for 2019, then a claim for refund may be in place.  

A more interesting call is planning for any 2020 contributions.  For instance, with the Arizona credit, a decision might need to be made regarding whether to make the contribution in time to assure that the taxpayer could receive approval—that is, the available credits had not already been claimed.  The same sort of analysis of expected benefits would need to be undertaken and tested against the two-pronged test of the regulations.

Advisers likely should recognize that the omission of income tax based credits from the safe harbor treatment for passthoughs likely occurred because the IRS is serious about taxpayers documenting compliance with the requirements in the two-pronged test.

If a client’s facts are like those in the Marquis case, the analysis is fairly simple. But advisers will likely find that most of their clients have situations that aren’t remotely comparable to Marquis—so the question then becomes just how far can the taxpayer stray from Marquis level facts and still be able to meet the two pronged test.

[1] REG-107431-19, December 17, 2019

[2] Proposed Reg. §1.162-15(a)(1)

[3] Harrison, Robert E., “Payments to charities by business enterprises: Sec. 162 vs. Sec. 170..” The Free Library, Retrieved Sep 05 2018 from https://www.thefreelibrary.com/Payments+to+charities+by+business+enterprises%3a+Sec.+162+vs.+Sec.+170.-a017170945

[4] Marquis v. Commissioner, 49 TC 695, 701 (1968)

[5] Reg. §1.170A-1(h)(2)(i) as revised by REG-107431-19

[6] REG-107431-19, December 17, 2019, Preamble Proposed Applicability Dates

[7] REG-107431-19, December 17, 2019, Preamble Proposed Applicability Dates