Proposed regulations released by the IRS on Friday provide guidance on the treatment of payments made to charitable organizations in exchange for consideration, including in exchange for state and local tax credits (REG-107431-19). The regulations incorporate two previous pieces of IRS guidance, Rev. proc. 2019-12 and Notice 2019-12, as well as other matters. The proposed regulations provide further guidance on the issue of attempts by states and taxpayers to avoid the $10,000 cap on state and local tax deductions by making charitable contributions instead (see TD 9864). The IRS says it received more than 7,700 comments on the topic after issuing a draft rulebook (REG-112176-18) in August 2018.
The proposed new regulations provide updates to the current Sec. 162 regulations to reflect statutory changes regarding how Sec. 162 applies when taxpayers make a payment to a Sec. 170(c) charitable organization for commercial purposes. They also provide secure ports under Sec. 162 for payments made by businesses to Sec. 170(c) organizations and under Sec. 164 for payments made to a Sec. 170(c) organization by individual taxpayers who itemize and receive (or expect to receive) a state or local tax credit in exchange for payment. Finally, they update the regulations to reflect previous guidance and case law on the application of the quid pro quo principle under Sec. 170 to benefits received (or expected) by a donor from a third party.
Payments by companies in exchange for tax credits
With respect to the first question – how payments from business entities are handled – the proposed regulations would amend Regs. Second. 1.162-15(a) to more clearly reflect the current state of the law regarding a taxpayer’s payment or transfer to a Sec. 170(c) entity. If the taxpayer’s payment or transfer relates directly to his trade or business, and the payment is made with a reasonable expectation of commensurate financial return, the payment or transfer to Sec. 170(c) entity may constitute a qualifying deduction as Sec. 162 trade or business fee rather than a Sec. 170 charitable contribution. A proposed example illustrates that this rule applies regardless of whether the taxpayer expects to receive a state or local tax credit in return. This rule applies to C corporations as well as to flow-through entities.
The proposed regulations incorporate a Safe Harbor originally published in Rev. proc. 2019-12. Under this safe harbor, to the extent that a C Corporation or Specified Flow-Through Entity receives or expects to receive a state or local tax credit in exchange for payment to a Sec. 170(c) organization, the IRS considers it reasonable to conclude that there is a direct benefit and a reasonable expectation of a commensurate financial return to the entity in the form of a reduction in state or local taxes that the entity would otherwise be required to Pay. Safe Harbor allows a C Corporation or specified pass-through entity engaged in a trade or business to treat the portion of the payment that is equal to the amount of credit received or intended to be received as meeting the requirements of an expense of ordinary and necessary undertaking under Sec. 162. Safe harbor only applies to cash or near-cash payments.
A specified flow-through entity, for this purpose, is a business entity that is separate from its owners for all federal tax purposes, that carries on a trade or business under Sec. 162, is subject to state or local taxes incurred in the exercise of trade or business and which are imposed directly on the entity, and which, in return for payment to a Sec. 170(c) organization, 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 other than the state or local income tax.
These rules would apply to payments made on or after the date the proposed settlements are posted in the Federal Register (scheduled for December 17, 2019), but taxpayers can continue to apply Rev. proc. 2019-12, which applies to payments made on or after January 1, 2018.
Payments by individuals in exchange for tax credits
The proposed settlement also incorporates a safe harbor that the IRS published last June in Notice 2019-12. Under this safe harbor, an individual taxpayer who itemizes deductions and makes a payment to a Sec. 170(c) entity in exchange for a state or local tax credit may treat as a state or local tax payment for Sec. 164 purposes the part of this payment for which a Sec. 170, the charitable donation deduction would be disallowed under reg. Second. 1.170A-1(h)(3). This treatment is permitted in the tax year in which the payment is made, but only to the extent that the resulting credit is applied under national or local law to offset national tax or local of the individual for this tax year or the previous tax year. Any unused credit that may be carried forward may be treated as a state or local tax payment under Sec. 164 in the tax year or years in which the deferral credit is applied.
This safe harbor is proposed to apply to payments made on or after June 11, 2019 (the date on which Notice 2019-12 was issued); however, taxpayers can rely on the proposed settlement for payments made after August 27, 2018.
Consideration provided by a third party
Under Reg. Second. 1.170A-1(h)(1), a payment a taxpayer makes to a Sec. 170(c) charitable organization that is in consideration for goods or services is not deductible, except to the extent that the payment exceeds the fair market value of the goods or services. Commentators have raised the question of whether Prop. Regs. Second. 1.170A-1(h)(3)(iii) interpretation of the definition of “in consideration of” in Regs. Second. 1.170A-13(f)(6) left open the possibility that consideration provided by a third party would be ignored when calculating a deduction for charitable contribution.
The proposed regulation would amend O. Reg. Second. 1.170A-1(h) to clarify that the consideration principle applies regardless of whether the party providing the consideration is the donee or a third party. In either case, the donor’s payment is not a charitable contribution since the donor expects to receive a substantial benefit in return. These proposed amendments would apply to payments made on or after the date the proposed regulations are published in the Federal Register.
— Sally P.SchreiberJD, (Sally.Schreiber@aicpa-cima.com) is a Jofa editor-in-chief.