United States

Safe harbor for businesses making quid pro quo contributions

TAX ALERT  | 

On Dec. 28, 2018, the IRS released Rev. Proc. 2019-12, which provides a safe harbor under section 162 for C corporations and certain pass-through entities making payments to charities or government entities in exchange for state or local tax credits.

Background

Section 164(b)(6), as added by section 11042 of Pub. L. No. 115-97, 131 Stat. 2054 (commonly referred to as the "Tax Cuts and Jobs Act” or “TCJA”), limits an individual’s deduction under section 164 for the aggregate amount of state and local tax payments made during the calendar year to $10,000 (or $5,000 for those married filing separately).

On Aug. 23, 2018, the IRS and Treasury issued proposed regulations that negate certain state laws designed to circumvent the $10,000 cap. In light of the new $10,000 state and local tax deduction limit, IRS and Treasury believe that when a taxpayer receives or expects to receive a state or local tax credit in return for a payment, the resulting federal tax benefit constitutes a quid pro quo that precludes a deduction under section 170(a) to the extent of the quid pro quo. Accordingly, the proposed regulations amended the regulations under section 170 to require a taxpayer to reduce his or her charitable deduction in the amount of any state and local tax credit received or expected in exchange for the donation.

In response to taxpayer inquiries, the IRS issued IR-2018-178 and the State and Local Income Tax FAQ to clarify that curtailment provisions in the proposed regulations under section 170 apply to business taxpayers. In addition, the guidance indicated that businesses may treat the payments to charities or government entities in exchange for state and local tax credits as deductible under section 162 for payments made with a business purpose. Thus, under the guidance any business taxpayer could deduct such payments as business expenses as long as the amounts qualify as ordinary and necessary business expenses.

The safe harbor

Since the release of the FAQ, Treasury and IRS continued to receive questions related to the application of the proposed regulations to taxpayers engaged in trades or businesses. Specifically, taxpayers inquired whether the quid pro quo contributions directly related to the taxpayer’s trade or business, such that they qualify as ordinary and necessary under section 162. If a C corporation and certain pass-through entities meet certain requirements, the Rev. Proc. concludes that the payments provide a direct benefit.

Under the safe harbor, if a C corporation makes a payment to or for the use of a state entity or charity described in section 170(c) and in exchange receives or expects to receive a tax credit for state or local taxes, then the C corporation my treat such payment as meeting the ordinary and necessary requirements of section 162 to the extent of the credit.

To qualify for the safe harbor, a pass-through entity must:

  1. Qualify as a business entity regarded as separate from its owners
  2. Operate as a trade or business under section 162
  3. Have state or local taxes imposed directly on the entity in carrying on its trade or business
  4. Apply the state or local credit as an offset to a state or local tax other than a state or local income tax

The exclusion of state or local income taxes from the safe harbor may have an impact on any new state law workarounds related to individual limitation of $10,000 that impose state or local income taxes on pass-through entities.

The Rev. Proc. applies to payments made on or after Jan. 1, 2018.

Takeaways

The Rev. Proc. provides confirmation to businesses meeting the requirements of the safe harbor that quid pro quo contributions qualify as ordinary and necessary under section 162. Taxpayers making such payments should consult their tax adviser to make sure they characterize payments properly to qualify for deductions. 

Check RSM’s Tax Reform Resource Center for the latest analysis on this and other developments related to tax reform.

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