The IRS has released final regulations updating guidance on cases when a payment to a charity will be treated as a payment of an ordinary and necessary business expense under IRC §162 in TD 9907.[1] The regulations also contain provisions that clarify situations when a donation to a charity that results in a credit against state and local taxes can be deducted as an additional payment of those taxes.

Payments Treated as Trade or Business Expenses under IRC §162

The final regulations retain the provision found in the proposed regulations, updating Reg. §1.162-15(a) that provides a test to determine if a payment to a charitable organization qualifies as a trade or business expense under IRC §162. The regulation provides:

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).[2]

Why is it important if the payment is a charitable contribution vs. a business expense? Normally a business expense deduction gets a more favorable tax treatment than a charitable contribution. Some of the benefits to having the payment reclassified can include:

No percentage of adjusted gross income (for individuals) or taxable income (for a C corporation) limitation on the annual deduction exists for §162 expenses, while charitable contributions are subject to such restrictions;
No need for an individual to itemize deductions to obtain a tax benefit if the deduction is under IRC §162 for a business (other than as an employee) conducted by the taxpayer or which has income flow through to the taxpayer; and
The deduction reduces a taxpayer’s adjusted gross income rather than taxable income, potentially allowing a taxpayer to receive a tax benefit that would not be available or would be reduced if the taxpayer’s adjusted gross income was higher.

But note that for the payment to be treated as a trade or business expense, the business must show two things:

A direct relationship of the payment to the taxpayer’s trade or business and
The payment was made with a reasonable expectation of a financial return commensurate with the amount of the payment or transfer.[3]

As the IRS did when the proposed regulations were issued, the IRS directs taxpayers to review the analysis in the case of Marquis v. Commissioner, 49 T.C. 695 (1968) to understand how to meet the tests.

We discussed the Marquis case when the proposed regulations were issued in January[4] and the issue remains the same—in Marquis the taxpayer had clearly calculated her likely additional business related to her “contributions” and stopped contributing to organizations when it became clear they wouldn’t use her services.

The regulation provides the following example of applying this rule:

Example 1, Reg. §1.162-15(a)(2)(i)

A, an individual, is a sole proprietor who manufactures musical instruments and sells them through a website. A makes a $1,000 payment to a local church (which is a charitable organization described in section 170(c)) for a half-page advertisement in the church’s program for a concert. In the program, the church thanks its concert supporters, including A. A’s advertisement includes the URL for the website through which A sells its instruments. A reasonably expects that the advertisement will attract new customers to A’s website and will help A to sell more musical instruments. A may treat the $1,000 payment as an expense of carrying on a trade or business under section 162.

In response to our article on the proposed regulations, we received a number of inquiries from advisers who had been told by charities (primarily what the IRS will refer to in the preamble as scholarship granting organizations, or SGOs) that the above regulation allowed a full deduction anytime a passthrough organization made a donation to such an entity and even that there was no requirement to show either the connection to the trade or business or demonstrate an expectation of a return in excess of the amount contributed. Such organizations often openly marketed such contributions to their organizations as work-arounds for the $10,000 limit on deductions on non-business state and local taxes under IRC §164.

Some of that was driven by an example, also contained in the final regulations, that applied this rule to a passthrough entity.

Example 2, Reg. §1.162-15(a)(2)(ii)

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. (emphasis added)

It continues to be the author’s position that the organizations are claiming, or at least strongly implying, more than the regulation allows by its clear language—and that the example is consistent with that position. While the last paragraph indicate the deduction could be allowed even if it resulted in a income tax credit passed out to the equity holders (as is the case in some of these programs), it also provided that the partnership found a reasonable expectation that the contribution would increase goodwill and revenue significantly, a point I’ve not found emphasized in much of the marketing material.

As well, the IRS noted in the preamble that one commentator had “requested clarification regarding whether a business entity may deduct payments to SGOs under section 162 as ordinary and necessary business expenses incurred in carrying on a trade or business.” The IRS did not provide that sort of specific clarification, rather it provided in the preamble:

While the Treasury Department and the IRS acknowledge these concerns, the regulations retain the clarifications to §1.162-15(a)(1) and (a)(2) regarding section 162 deductions for business payments to section 170(c) entities, as well as examples illustrating the rule. Section 1.162-15(a)(1) mirrors the language of §1.170A-1(c)(5), which has been in effect since 1970. Section 1.170A-1(c)(5) provided that if the taxpayer’s payment or transfer bears a direct relationship to its trade or business, and the payment is made with a reasonable expectation of commensurate financial return, the payment or transfer may constitute an allowable deduction as a trade or business expense under section 162, rather than a charitable contribution under section 170. See also Marquis v. Commissioner, 49 T.C. 695 (1968). Section 1.162-15(a)(1) applies the same standard. Thus, a passthrough entity may deduct a payment under §1.162- 15(a)(1) only if the entity can demonstrate that the payment satisfies these requirements, which limits the possibility of abuse. (emphasis added)

Some have objected that, in a case where a credit equal to 100% of the amount contributed is allowed for a contribution (something the state of Arizona, for one, does allow), the contribution would always meet the requirement of a benefit beyond the amount paid by the business. However, that view ignores the fact the regulation requires that the taxpayer (in this case the passthrough) have a reasonable expectation of a financial return. When the credit is passed out to the equity holders, it is they and not the passthrough taxpayer, that would receive any return.

As well, that analysis also ignores the requirement that payment bear a direct relationship to the taxpayer’s trade or business. Without a substantial benefit aside from the indirect payment of personal income taxes of the equity holder(s), it would appear very difficult to articulate a reasonable direct relationship. Such a transaction appears also to pose issues of lacking economic substance as that term is defined at IRC §7701(o).

Safe Harbor for Certain Payments to Charities in Exchange for State or Local Credits

The final regulations retain, without any significant changes, the safe harbor rules for certain charitable contributions for which a business receives a state or local tax credit.

The preamble provides the following justification for these safe harbor provisions:

To the extent that a C corporation or specified passthrough entity 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 and a reasonable expectation of commensurate financial return to the C corporation’s or specified passthrough entity’s business in the form of a reduction in the State or local taxes that the entity would otherwise be required to pay. Thus, the final regulations provide safe harbors that allow a C corporation or specified passthrough entity engaged in a trade or business to treat the portion of the payment that is equal to the amount of the credit received or expected to be received as meeting the requirements of an ordinary and necessary business expense under section 162. The safe harbors for C corporations and specified passthrough entities apply only to payments of cash and cash equivalents.

But the preamble notes one key caveat to this analysis: “The safe harbor for specified passthrough entities does not apply if the credit received or expected to be received reduces a State or local income tax.”

Safe Harbor for C Corporations

The regulations provide the following safe harbor rule applicable to C corporations:

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.[5]

This safe harbor is shorter and simpler than the one for passthrough entities discussed next. A key reason for its simplicity is that virtually all of the taxes paid by C corporation are allowed as a deduction under IRC §164 without limitation.

Safe Harbor for Specified Passthrough Entities

A more involved safe harbor exists for certain passthrough entities, referred to as specified passthrough entities. To be a specified passthrough entity eligible to use the safe harbor, all of the following requirements must be satisfied:

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 9 (that is, it cannot be a disregarded entity, such as a single member LLC or a grantor trust);
The entity operates a trade or business within the meaning of section 162 (thus, investment partnerships would not qualify);
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 (note that a state income tax imposed on the equity holder for income reported from the entity would not qualify); and
In return for a payment to a qualified charity, the passthrough 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 the previous bullet point.[6]

If an entity meets the above requirements, it is eligible to make use of the following safe harbor to enable a deduction for the amount paid as a §162 trade or business expense:

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 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.[7]

But note the “except as provided” language in the safe harbor. That exception is a fairly significant one for the passthrough entity:

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.[8]

Quid Pro Quo Benefits from a Party Other Than the Charity

The IRS also rejected comments that claimed that a quid pro quo benefit that comes from a party other than the charity should not reduce a claimed charitable deduction. Such a ruling would enable many of the state tax credit qualified contributions to continue to be deducted in full without a reduction to take into account a personal income tax or real estate tax reduction received when such a contribution is made.

The IRS declined to issue regulations providing for such a distinction. As the preamble states:

The Treasury Department and the IRS considered these comments, but did not adopt the suggested changes because the established tax law does not support them. As discussed in the preamble to the proposed regulations, both the courts and the IRS have concluded that the quid pro quo principle is equally applicable, regardless of whether the donor expects to receive the benefit from the donee or from a third party. See, e.g., Singer v. United States, 449 F.2d 413 (Ct. Cl. 1971) (rejecting the taxpayer’s argument that an expected benefit should be ignored because it would be received from a third party); Rev. Rul. 67-246, 1967-2 C.B. 104 (concluding that the donor’s charitable contribution deduction must be reduced by the value of a transistor radio provided by a local store). Moreover, the courts have concluded that a taxpayer’s expectation of a substantial benefit in return, from any source, reflects a lack of requisite charitable intent on the part of the donor. See, e.g., Ottawa Silica Co. v. United States, 699 F.2d 1124 (Fed. Cir. 1983) (denying a charitable contribution deduction for the value of land donated for the construction of a school, where the taxpayer had reason to believe such construction would ultimately increase the value of its land). Thus, the source of the consideration is immaterial in determining whether a donor has received or expects to receive a return benefit that reduces its charitable contribution deduction.

Safe Harbor for Payments by an Individual in Exchange for State or Local Tax Credits

The final regulations retain the safe harbor allowing a deduction for individuals as a payment of state or local taxes for certain payments made to charities that qualify a taxpayer for a credit against state or local taxes. Of course, since the payment is treated as a payment of taxes under §164, it will only give a benefit to the extent payments for other taxes subject to the general $10,000 limit on individual state and local taxes deducted on Schedule A not related to a §212 activity fall short of that limit. Just in case that wasn’t clear, the regulations provide:

Nothing in this paragraph (j) may be construed as permitting a taxpayer who applies this safe harbor to avoid the limitation of section 164(b)(6)[9] for any amount paid as a tax or treated under this paragraph (j) as a payment of tax.[10]

The safe harbor only allows a deduction in the year in which the credit actually reduces the state and local tax of the taxpayer:

To the extent that a State or local tax credit described in paragraph (j)(1) of this section is not applied to offset the individual’s applicable State or local tax liability for the taxable year of the payment or the preceding taxable year, any excess State or local tax credit permitted to be carried forward may be treated as a payment of State or local tax under section 164(a) in the taxable year or years for which the carryover credit is applied in accordance with State or local law.[11]

The safe harbor provides:

An individual who itemizes deductions and who makes a payment to or for the use of an entity described in section 170(c) in consideration for a State or local tax credit 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 disallowed under §1.170A-1(h)(3). This treatment as payment of a State or local tax is allowed in the taxable year in which the payment is made to the extent that the resulting credit is applied, consistent with applicable State or local law, to offset the individual’s State or local tax liability for such taxable year or the preceding taxable year.[12]

The safe harbor only applies to cash contributions, not those of property.[13] As well, a payment cannot be deducted under this safe harbor and under another provision of the IRC.[14]

[1] TD 9907, August 7, 2020, https://s3.amazonaws.com/public-inspection.federalregister.gov/2020-17393.pdf?utm_campaign=pi+subscription+mailing+list&utm_source=federalregister.gov&utm_medium=email (

[2] Reg. §1.162-15(a)

[3] Reg. §1.162-15(a)

[4] Edward Zollars, “IRS Example Suggests Possible State Tax Workaround for Certain Passthrough Credits,” Current Federal Tax Developments website, January 15, 2020, https://www.currentfederaltaxdevelopments.com/blog/2020/1/15/irs-example-suggests-possible-state-tax-workaround-for-certain-passthrough-credits (retrieved August 7, 2020)

[5] Reg. §1.162-15(a)(3)(i)

[6] Reg. §1.162-15(a)(3)(ii)(A)

[7] Reg. §1.162-15(a)(3)(ii)(B)

[8] Reg. §1.162-15(a)(3)(ii)(C)

[9] The $10,000 limit.

[10] Reg. §1.164-3(j)(3)

[11] Reg. §1.164-3(j)(2)

[12] Reg. §1.164-3(j)(1)

[13] Reg. §1.164-3(j)(4)

[14] Reg. §1.164-3(j)(5)