The issue of the application of IRC §265(a)(1) and how it bars a deduction has been widely discussed with relation to the PPP loan program. But the IRS looked at the section again in CCA 202027003[1] in relation to the deduction for charitable contributions under IRC §512(b)(10) for the unrelated business income tax.

The CCA has been issued to answer the following question:

Whether under section 265(a)(1) of the Internal Revenue Code, the charitable contribution deduction allowed under section 512(b)(10) is allocable to tax-exempt income and therefore not deductible in calculating unrelated business taxable income under section 512(a)(1)?

IRC §512(b)(10) provides:

(10) In the case of any organization described in section 511(a), the deduction allowed by section 170 (relating to charitable etc. contributions and gifts) shall be allowed (whether or not directly connected with the carrying on of the trade or business), but shall not exceed 10 percent of the unrelated business taxable income computed without the benefit of this paragraph.

The question involves the bar to deduction found at IRC §265(a)(1) which provides:

(a) General rule. No deduction shall be allowed for—

(1) Expenses

Any amount otherwise allowable as a deduction which is allocable to one or more classes of income other than interest (whether or not any amount of income of that class or classes is received or accrued) wholly exempt from the taxes imposed by this subtitle, or any amount otherwise allowable under section 212 (relating to expenses for production of income) which is allocable to interest (whether or not any amount of such interest is received or accrued) wholly exempt from the taxes imposed by this subtitle.

Since the unrelated business income tax is applied to what is otherwise a charitable organization, the question arises whether the charity is making that contribution from non-UBI income that is exempted from tax—and if that would then bar the deduction under IRC §265(a)(1).

The memorandum concludes that answer is no. The memorandum begins by looking at how the courts have determined when a deduction is allocable to tax-exempt income:

In order to determine if expenses are allocable to tax-exempt income for purposes of section 265(a)(1), courts have looked to whether the expenses were “intended to be covered” by tax-exempt income or whether the expenses would not exist “but for” the tax-exempt income. See Induni v. Commissioner, 990 F.2d 53 (1993); Dalan v. Commissioner, T.C. Memo. 1988-106. Similarly, Rev. Rul. 83-3 disallows expenses under section 265(a)(1) that were incurred for the purpose of earning or otherwise producing tax-exempt income and expenses that were incurred in carrying out the specific purpose to which the tax-exempt income is earmarked. 1983-1 C.B. 72, modified by Rev. Rul. 87-32, 1987-1 C.B. 131.

The memorandum then notes that, in order for an expenditure to be a deductible charitable contribution under IRC §170, it has to be a purely gratuitous transfer:

In order to establish that a “contribution or gift” has been made under section 170, a taxpayer must show a voluntary and irrevocable transfer of ownership of money or property without the receipt of adequate consideration or a substantial return benefit. See United States v. American Bar Endowment, 477 U.S. 105, 116 (1986); see also Transamerica Corp. v. United States, 902 F.2d 1540 (Fed. Cir. 1990); Singer Co. v. United States, 449 F.2d 413 (Ct. Cl. 1971). In determining whether a taxpayer has made a contribution without the expectation of any return benefit or quid pro quo, the “external features of the transaction in question” are examined. Hernandez v. Commissioner, 490 U.S. 680, 690 (1989). In addition, the taxpayer is required to have charitable intent in making the contribution. See American Bar Endowment, 477 U.S. at 118.

Based on this analysis, the memorandum concludes that §265(a)(1) will not bar the deduction in this case:

A charitable contribution is, by its nature, not allocable to any source of income, but instead arises from a donor’s charitable intent to voluntarily transfer money or property without receiving any benefit in return. Consequently, section 265(a)(1) may not be applied to disallow Organization’s charitable contribution deduction claimed in computing UBTI under section 512(a)(1).

[1] CCA 202027003, July 2, 2020, https://www.irs.gov/pub/irs-wd/202027003.pdf (retrieved July 3, 2020)