In August 2018, the IRS released proposed regulations that limit federal charitable contribution deductions if a state tax credit is received in return. The rules are designed to prevent taxpayers from circumventing the $10,000 limit and on state and local tax (SALT) deductions included in the Tax Cuts and Jobs Act. Since the publication of the regulations, business taxpayers have asked the IRS for clarification on whether they can still take business expense deductions for contributions to charities. (See earlier coverage.) In response, the IRS has issued Revenue Procedure 2019-12, which provides safe harbors for C Corporations and passthrough entities that receive state tax credits in return for charitable contributions.
The safe harbors adopt an assumption that payments made by business taxpayers to charitable organizations in return for state credits “bear a direct relationship to the taxpayer’s trade or business”, and “are made with a reasonable expectation of financial return.” These two criteria are required for federal business expense deductions.
This is bad news for the Georgia Rural Hospital Tax Credit program and other programs that states had put in place to address unique needs.
Passthroughs Can’t Offset Income Taxes
The IRS offers separate explanations and examples for C Corporations and for passthrough entities, such as S Corporations, LLCs, and partnerships. C Corporations can take federal business expense deductions for payments that offset any type of state tax. The rule for passthrough entities is more restrictive. Passthrough entities can only take deductions for state credits that offset a state or local tax other than an income tax and that are imposed at the entity level. This distinction is illustrated below.
C Corporation Safe Harbor and Examples
If a C corporation makes a payment to a charitable organization and receives a state or local tax credit that reduces the C Corporation’s state tax, the corporation may treat the payment as a deductible business expense.
Example 1. ABC, a C corporation, makes a payment of $1,000 to a charitable organization. In return, ABC receives a dollar-for-dollar state tax credit to be applied to A’s state corporate income tax liability. ABC may treat the $1,000 payment as an ordinary and necessary business expense on its federal return.
Example 2. BCD, a C corporation, makes a payment of $1,000 to charity. In return, BCD receives an 80% tax credit ($800) to be applied to BCD’s local real property tax liability. BCD may treat $800 as a deductible business expense on its federal return. The treatment of the remaining $200 will depend upon the facts and circumstances and is not affected by the revenue procedure.
Passthrough Safe Harbor and Examples
Passthrough entities are subject to more restrictions. To take a federal business expense deduction for a state charitable contribution, a passthrough must meet the following requirements:
(1) The entity is a business entity that must be treated under federal tax law as separate from its owners;
(2) The entity operates a trade or business;
(3) The entity is subject to a state or local tax that is imposed directly on the entity; and
(4) In return for the charitable payment, the entity receives a state or local tax credit that offsets a state or local tax other than a state or local income tax.
Thus, the safe harbor cannot be used by individual owners to get around the federal SALT limitation because the business expense deduction cannot be taken for payments that offset state or local income taxes.
Example 1. P is an LLC classified as a partnership for federal tax purposes and is owned by individuals A and B. P is engaged in a trade or business and makes a payment of $1,000 to a charity. In return, P receives a dollar-for-dollar state tax credit against its state excise tax liability, which is imposed at the entity level. P may treat the $1,000 payment as a deductible ordinary and necessary business expense.
Example 2. Q is an S corporation engaged in a trade or business and is owned by individuals C and D. Q pays $1,000 to a charitable organization. In return, Q receives an 80% state tax credit ($800) to be applied to Q’s local real property tax liability. Under local law, the real property tax is imposed at the entity level, not the owner level. Q may treat $800 of the payment as meeting the requirements of an ordinary and necessary business expense. The treatment of the remaining $200 will depend upon the facts and circumstances and is not affected by the safe harbor rule.
No Multiple Deductions
The IRS notes in its guidance that the safe harbors are not intended to allow any entity to take deductions under more than one provision of the federal Code or regulations. In other words, entities cannot take both a federal business expense deduction and a federal charitable deduction for the same contribution.