IRS Finalizes Regs on Charitable Donations Made in Exchange for Consideration

(Parker Tax Publishing August 2020)

The IRS issued final regulations under Code Sec. 162 and Code Sec. 164 that (1) update the regulations under Code Sec. 162 to reflect current law regarding the application of Code Sec. 162 to taxpayers that make payments or transfers for business purposes to entities described in Code Sec. 170(c); (2) provide safe harbors under Code Sec. 162 with respect to the treatment of payments made by business entities to entities described in Code Sec. 170(c), and (3) provide a safe harbor under Code Sec. 164 for payments made to a tax-exempt entity described in Code Sec. 170(c) by individuals who itemize deductions and receive or expect to receive a state or local tax credit in return. In addition, the final regulations update the regulations under Code Sec. 170 to reflect past guidance and case law regarding the application of the quid pro quo principle under Code Sec. 170 to a donor who receives or expects to receive benefits from a third party. T.D. 9907.

Background

Code Sec. 170(a)(1) generally allows an itemized deduction for any charitable contribution paid within the tax year. Under Code Sec. 170(c), a charitable contribution is a contribution or gift to or for the use of any entity described in that section. Such entities include a state, a possession of the United States, or any political subdivision thereof, and certain entities organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes.

Reg. Sec. 1.170A-1(c)(5) provides that transfers of property to an organization described in Code Sec. 170(c) that bears a direct relationship to the taxpayer's trade or business and that are made with a reasonable expectation of financial return commensurate with the amount of the transfer may constitute allowable deductions as trade or business expenses under Code Sec. 162(a) rather than as charitable contributions. Prior to amendment by the final regulations in T.D. 9907, Reg. Sec. 1.162-15(a)(1) provided that no deduction was allowable under Code Sec. 162(a) for a contribution or gift by an individual or a corporation if any part thereof was deductible under Code Sec. 170. Reg. Sec. 1.162-15 was clarified in the proposed regulations with respect to Code Sec. 162 deductions for business payments to Code Sec. 170(c) entities so that the regulation now mirrors the language of Reg. Sec. 1.170A-1(c)(5). Under Reg. Sec. 1.170A-1(c)(5), 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 Code Sec. 162, rather than a charitable contribution under Code Sec. 170. In Prop. Reg. 1.162-15(a)(1), the IRS applied the same standard.

Code Sec. 164(a) allows a deduction for the payment of certain taxes, including: (1) state and local, and foreign, real property taxes; (2) state and local personal property taxes; and (3) state and local, and foreign, income, war profits, and excess profits taxes. In addition, Code Sec. 164 allows a deduction for taxes that are paid or accrued within the tax year in carrying on a trade or business or an activity described in Code Sec. 212. Code Sec. 164(b)(6), as added by the Tax Cuts and Jobs Act of 2017 (TCJA), provides that, in the case of an individual, the deduction for the aggregate amount of the state and local taxes paid during the calendar year is limited to $10,000 ($5,000 in the case of a married individual filing a separate return). This limitation applies to tax years beginning after December 31, 2017, and before January 1, 2026, and does not apply to any state and local property taxes that are paid or accrued in carrying on a trade or business or an activity described in Code Sec. 212. In response to the Code Sec. 164(b)(6) limitation, some taxpayers have considered tax planning strategies to avoid or mitigate its effects. Some of these strategies rely on state and local tax credit programs under which states provide tax credits in return for contributions to entities described in Code Sec. 170(c), and some state and local governments have created new programs intended to facilitate use of these strategies.

In August of 2018, the IRS issued proposed regulations (REG-112176-18) under Code Sec. 170 and Code Sec. 642(c) (2018 proposed regulations). The 2018 proposed regulations proposed amending Reg. Sec. 1.170A-1(h)(3) to provide, in general, that if a taxpayer makes a payment or transfers property to or for the use of an entity described in Code Sec. 170(c), and the taxpayer receives or expects to receive a state or local tax credit in return, the tax credit constitutes a return benefit and reduces the taxpayer's charitable contribution deduction. The 2018 proposed regulations also proposed amending regulations under Code Sec. 642(c) to provide a similar rule for payments made by a trust or decedent's estate.

In December of 2018, the IRS issued Rev. Proc. 2019-12 to provide a safe harbor under Code Sec. 162 for payments made by a C corporation or specified passthrough entity to, or for the use of, an organization described in Code Sec. 170(c) if the C corporation or specified passthrough entity receives or expects to receive state or local tax credits in return. In addition, a safe harbor was provided in June of 2019 under Code Sec. 164 in Notice 2019-12 for individuals who make payments to Code Sec. 170(c) entities in return for state or local tax credits.

In June of 2019, the IRS issued final regulations in T.D. 9864 (2019 final regulations) addressing the proper application of Code Secs. 164 and 170 to taxpayers who make contributions under state and local tax credit programs to entities described in Code Sec. 170(c). The 2019 final regulations provide the general rule that, if a taxpayer makes a payment or transfers property to or for the use of an entity described in Code Sec. 170(c), and the taxpayer receives or expects to receive a state or local tax credit in return, the tax credit constitutes a return benefit or quid pro quo, reducing the taxpayer's charitable contribution deduction. The 2019 final regulations also amended regulations under Code Sec. 642(c) to provide similar rule for payments made by a trust or decedent's estate.

In December of 2019, the IRS issued proposed regulations under Code Secs. 162, 164, and 170 (REG-107431-19), which include the safe harbors provided under Rev. Proc. 2019-12 and Notice 2019-12, and clarify the application of the quid pro quo principle under Code Sec. 170 to benefits received or expected to be received from third parties.

Practitioners' Concerns

While practitioners mostly expressed support for the proposed regulations and recommended that the IRS finalize the regulations, a number of practitioners expressed concerns about the impact of the 2019 final regulations on state and local programs granting tax credits for contributions by individuals and businesses to scholarship granting organizations (SGOs). SGOs are entities described in Code Sec. 170(c) that receive contributions from individuals and businesses and then disburse these funds as scholarships to enable eligible students to attend qualified private schools. Other practitioners were concerned that, even with certain clarifications in the proposed regulations, the 2019 final regulations have resulted in, and will continue to result in, decreased contributions to SGOs and other Code Sec. 170(c) entities.

Multiple practitioners also expressed concern that passthrough entity owners may circumvent the Code Sec. 164(b)(6) limitation by recharacterizing the portion of the payment that is not deductible under Code Sec. 170 as a business expense deductible under Code Sec. 162. One practitioner requested clarification regarding whether a business entity may deduct payments to SGOs under Code Sec. 162 as ordinary and necessary business expenses incurred in carrying on a trade or business. A few practitioners expressed concerns that the regulations may incentivize payments to education programs that discriminate against students with disabilities or that divert tax dollars from public schools to private schools. One practitioner opined that state and local programs providing tax credits to businesses that donate to certain charitable organizations run counter to the concept of charity because donors should expect nothing in return for a donation.

In addition, some practitioners expressed a belief that, under current law, a quid pro quo received or expected to be received by a taxpayer does not reduce the taxpayer's charitable contribution deduction if the quid pro quo comes from a party that is not the donee. Those practitioners emphasized that the use of state or local tax credits in exchange for donations to SGOs is not intended to subvert federal tax law.

Final Regulations

The IRS finalized the proposed regulations published in REG-107431-19 with the issuance of T.D. 9907. The final regulations retain the proposed amendments to Reg. Sec. 1.162-15(a) to clarify that a taxpayer's payment or transfer to a Code Sec. 170(c) entity may constitute an allowable deduction as a trade or business expense under Code Sec. 162, rather than a charitable contribution under Code Sec. 170. Thus, under Reg. Sec. 1.162-15(a)(1), payments to Code Sec. 170(c) entities may be deducted under Code Sec. 162 if they bear a direct relationship to the taxpayer's trade or business and are made with a reasonable expectation of financial return commensurate with the amount paid. Additionally, a passthrough entity may deduct a payment under Reg. Sec. 1.162-15(a)(1) only if the entity can demonstrate that the payment satisfies these requirements, which, the IRS said, limits the possibility of abuse.

The final regulations also retain the safe harbors under Code Sec. 162 with respect to the treatment of payments made by business entities to an entity described in Code Sec. 170(c). Safe harbors are provided under Code Sec. 162 for payments made by a business entity that is a C corporation or specified passthrough entity to or for the use of an organization described in Code Sec. 170(c) if the C corporation or specified passthrough entity receives or expects to receive state or local tax credits in return. A C corporation or specified passthrough entity engaged in a trade or business may treat the portion of the payment that is equal to the amount of the credit as meeting the requirements of an ordinary and necessary business expense under Code Sec. 162. The safe harbors for C corporations and specified passthrough entities apply only to payments of cash and cash equivalents. 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.

The final regulations also retain the safe harbor under Code Sec. 164 for payments made to an entity described in Code Sec. 170(c) by individuals who itemize deductions and receive or expect to receive a state or local tax credit in return. An individual who itemizes deductions and who makes a payment to a Code Sec. 170(c) entity in exchange for a state or local tax credit may treat as a payment of state or local tax for purposes of Code Sec. 164 the portion of such payment for which a charitable contribution deduction under Code Sec. 170 is disallowed under Reg. Sec. 1.170A-1(h)(3). Any payment treated as a state or local tax under Code Sec. 164, pursuant to the safe harbor provided in Reg. Sec. 1.164-3(j) of the final regulations, is subject to the limitation on deductions in Code Sec. 164(b)(6).

The IRS said that, while it recognized the importance of the federal charitable contribution deduction, as well as state and local tax credit programs, in encouraging charitable giving, the concerns expressed by practitioners with respect to SGOs related more directly to the 2019 final regulations, and the statutory limitation on individuals' deductions of state and local taxes under Code Sec. 164, than to the current final regulations. The IRS noted that the 2019 final regulations continue to allow a charitable contribution deduction for the portion of a taxpayer's contribution that is a gratuitous transfer, and do not affect the ability of states or localities to provide state or local tax incentives. In addition, the final regulations provide additional clarity to businesses that make payments or transfers to or for the use of SGOs and other entities described in Code Sec. 170(c). Similarly, the IRS observed, the safe harbor provided under Reg. Sec. 1.164-3(j) of the final regulations for individuals who itemize deductions will ensure equitable treatment for taxpayers whose deductions for state and local tax payments would not have exceeded the Code Sec. 164(b)(6) limitation.

Finally, the final regulations retain the amendments to the regulations under Code Sec. 170 to reflect past guidance and case law regarding the application of the quid pro quo principle under Code Sec. 170 to a donor who receives or expects to receive benefits from a third party. The final regulations clarify that the quid pro quo principle applies regardless of whether the party providing the quid pro quo is the donee or a third party. Under the final regulations, a taxpayer will be treated as receiving goods and services in consideration for a taxpayer's payment or transfer to an entity described in Code Sec. 170(c) if, at the time the taxpayer makes the payment or transfer, the taxpayer receives or expects to receive goods or services in return. For additional clarity, the final regulations amend Reg. Sec. 1.170A-1(h)(2)(i)(B) to state that the fair market value of goods and services includes the value of goods and services provided by parties other than the donee.

For a discussion of the limitation on charitable contribution deductions that involve a quid pro quo with respect to state taxes, see Parker Tax ¶83,150.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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