Tuesday, February 12, 2019
Revenue Procedure 2019-12 provides for a seemingly unjustifiable horizontal inequity when it comes to individual state and local taxes. I could be wrong, these are just my first thoughts and I should probably ponder it a little more. But deadlines never stop! Recall that as a result of the TCJA, individual deductions for state and local taxes are capped at $10,000. State law efforts to use charitable deductions to "work around" SALT limitations were likely thwarted when the Treasury Department issued proposed regulations concluding that charitable contributions will not be allowed to avoid or undermine the $10,000 SALT limitation. In other words, if a state reduces state or local taxes by the amount of charitable contributions made, the federal contribution amount will be reduced by the amount of SALT reduction at the state level. Historically, corporations and other profit making entities could not make charitable contributions, proper, because a business entity is limited to profit-making purposes. Corporations exist to make profit not give away investors' money even for the most worthy cause. That was the lesson in Dodge v. Ford, a classic introductory case in every business organizations text. The oft-repeated distinction is that a corporation has the power to make a charitable contribution, but only for the purpose of making money. Today, the social purpose and benefit corporation statutes allow certain profit making corporations to have charitable purposes, even if they are not exempt under 501(c)(3). And corporate charitable contributions are generally viewed as "good business" leading to more profits in the long term.
So anyway, the proposed regulations effectively prevent charitable workarounds by individuals. The Revenue Procedure allows through a backdoor what the proposed regulations prevent through the front door, in limited but significant circumstances. In federal tax law, a passthrough entity -- especially a partnership -- works like a magic hat. Although it appears empty, the right person can stick his hand into the hat and pull out a rabbit! Individuals who want to make charitable contributions to reduce state and local taxes can use passthrough entities to get the charitable workaround that the proposed regulations deny to individuals who make the same charitable contribution directly. They simply have to stick their hand into the partnership hat and out pops a rabbit! Since corporations and partnerships exist to make money, theoretically every payment -- even a charitable contribution properly made for a profit seeking purpose (like the generation of good will and more customers) -- is a trade or business expense (or perhaps an expenditure). And trade or business deductions under IRC 162 are not reduced by the receipt or expectation of return benefit. The whole reason for making the deductible payment is to obtain a return benefit, albeit a profit making one. So here is what Revenue Procedure 2019-12 says about individuals who make charitable contributions through a partnership even if the payment reduces a state and local tax liability:
.03 Safe harbor. If a specified passthrough entity described in section 4.02 of this revenue procedure makes a payment to or for the use of an organization described in section 170(c) and receives or expects to receive a tax credit described in section 4.02(4) of this revenue procedure that the entity applies or expects to apply to offset a state or local tax described in section 4.02(3) of this revenue procedure other than a state or local income tax, the specified passthrough entity 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 credit received or expected to be received.
(1) Example 1. P is a limited liability company (LLC) classified as a partnership for federal income tax purposes under section 301.7701-3 and is owned by individuals A and B. P is engaged in a trade or business within the meaning of section 162 and makes a payment of $1,000 to an organization described in section 170(c). In return for the payment, P receives or expects to receive a dollar-for-dollar state tax credit to be applied to P’s state excise tax liability incurred by P in carrying on its trade or business. Under applicable state law, the state’s excise tax is imposed at the entity level (not the owner level). Under section 4 of this revenue procedure, P may treat the $1,000 payment as meeting the requirements of an ordinary and necessary business expense under section 162.
(2) Example 2. S is an S corporation engaged in a trade or business and is owned by individuals C and D. S makes a payment of $1,000 to an organization described in section 170(c). In return for the payment, S receives or expects to receive a state tax credit equal to 80 percent of the amount of this payment ($800) to be applied to S’s local real property tax liability incurred by S in carrying on its trade or business. Under applicable state and local law, the real property tax is imposed at the entity level (not the owner level). Under section 4 of this revenue procedure, S may treat $800 of the payment as meeting the requirements of an ordinary and necessary business expense under section 162. The treatment of the remaining $200 will depend upon the facts and circumstances and is not affected by this revenue procedure.
In both examples, the charitable contribution reduces state taxes (other than income taxes) payable at the entity level; for federal purposes the payment passes through to the members (in the LLC) and the shareholders (in the S Corporation) and reduces federal income dollar for dollar. But the passed-through charitable contribution deduction does not apply towards the $10,000 SALT limitation at the federal level, nor is it reduced for federal purposes by the amount of state tax liability reduction, because it retains its entity level characterization as an ordinary and necessary business expense (almost as if it were not an intentional workaround the SALT limitation when we know it is). Had the members or or shareholders made the charitable contributions directly and in return for the same state level tax reduction, the charitable contribution deduction would have been reduced by the amount of the state tax reduction. Importantly, the magic hat trick works only if the passthrough entity is subject to a state entity level tax and according to AICPA so far only thirteen states impose taxes at the entity level for an entity treated as a passthrough for federal purposes. Apparently, the only distinction between an individually made state tax offsetting charitable contribution and one made via a passthough is that in the latter circumstance, the individual has a profit-seeking purpose as a matter of law because of the existence of the partnership through which the contribution was made. The distinction does not resolve my cognitive dissonance! Maybe somebody can make an argument in defense of the outcome or better yet explain what I am missing! Or maybe this is not such a big deal. Somehow it does not feel right. In any event, AICPA reports that more states are considering enacting entity level taxes on partnerships so that partners may take advantage of the magic hat that is partnerships!
Darryll K. Jones and Harry Germeus