Taxing Definitions

Definition — Safe harbors and taxes

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Back in August, the IRS issued proposed regulations about the new limitation on federal income tax deductions for state and local income taxes (see Taxing Lessons post here).

After the proposed regulations were issued, the IRS continued to receive questions about the way those proposed regulations would apply to businesses. Specifically, taxpayers wanted to know whether businesses could continue to deduct payments to state and local tax credit programs run by qualified charitable organizations such as government entities.

At issue: Whether payments by businesses to these organizations in return for state income, property, and other business tax credits would bear a direct relationship to the taxpayer’s trade or business. (If so, the payments would be considered ordinary and necessary business expenses of carrying on such trade or business to the extent of the credit received or expected.)

Here is the relevant tax law:

From internal revenue code section 162(a): Allows a deduction for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.

From internal revenue code section 162(b): Provides that no deduction shall be allowed for any contribution or gift that would be allowed as a deduction were it not for the percentage limitations, the dollar limitations, or the requirements as to the time of payments.

From internal revenue code section 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.

From internal revenue code section 170(a)(1): Generally allows an itemized deduction for any “charitable contribution” paid within the taxable year.

From internal revenue code section 170(c): Defines “charitable contribution” as a “contribution or gift to or for the use of” organizations such as a state, a possession of the United States, or any political subdivision of the foregoing, including the District of Columbia. Also includes certain corporations, trusts, or community chests, funds, or foundations, organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes, or to foster national or international amateur sports competition, or for the prevention of cruelty to children or animals.

From internal revenue regulation section 1.170A-1(c)(5): Provides that transfers of property to an organization described in section 170(c) that bear 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 rather than as charitable contributions.

From internal revenue code section 164(b)(6), as added by section 11042(a) of “An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018”: Limits an individual’s deduction to $10,000 ($5,000 in the case of a married individual filing a separate return) for the aggregate amount of the following state and local taxes paid during the calendar year: (1) real property taxes; (2) personal property taxes; (3) income, war profits, and excess profits taxes, and (4) general sales taxes. This limitation applies to taxable years beginning after December 31, 2017, and does not apply to foreign taxes described in section 164(a)(3) or to any taxes described in section 164(a)(1) and (2) that are paid and incurred in carrying on a trade or business or an activity.

In Revenue Procedure 2019-12, the IRS provided safe harbors for C corporations and certain pass-through businesses. These rules apply to amounts that are paid on or after January 1, 2018.

Under the safe harbor for C corporations, a C corporation that receives a tax credit for payments to a qualified organization can deduct those payments as business expenses, to the extent of the credit received or expected to be received. The corporation has to make the payments in carrying on its trade or business.

1

A C corporation makes a payment of $1,000 to a qualified organization. In return, the corporation receives or expects to receive a dollar-for-dollar state tax credit to be applied to the corporation’s state corporate income tax liability.

Can the corporation deduct the payment under the safe harbor?

or

2

A C corporation makes a payment of $1,000 to a qualified organization. In return for the payment, the corporation receives or expects to receive a tax credit equal to 80% of the amount of the payment to be applied to the corporation’s local real property tax liability.

How much of the payment can the corporation deduct under the safe harbor?

or

Under the safe harbor for specified pass-through entities, a specified pass-through entity that receives a tax credit for payments to a qualified organization can deduct those payments as business expenses, to the extent of the credit received or expected to be received.

The pass-through has to be a business other than a C corporation that is regarded for all federal income tax purposes as separate from its owners. The pass-through must make the payments in carrying on its trade or business.

In addition, the tax must be a state or local tax incurred in carrying on the trade or business that is imposed directly on the pass-through.

Finally, the pass-through must receive or expect to receive a state or local tax credit that will be applied to offset a state or local tax other than a state or local income tax.

Editorial Note: While the pass-through entity will deduct and report the payments to the individual owners, final deductibility of the payment must be determined at the level of the individual owners of the entity if the credit received or expected to be received will reduce a state or local income tax subject to the limitations in the new law (see section 164(b)(6) above).

3

A limited liability company that is classified as a partnership for federal income tax purposes is owned by two individuals and operates as a business. The company makes a payment of $1,000 to a qualified organization. In return the company receives or expects to receive a dollar-for-dollar state tax credit to be applied to state excise tax liability. Under applicable state law, the state’s excise tax is imposed at the entity level (not the owner level).

Can the pass-through company deduct the payment under the safe harbor?

or

4

An S corporation engaged in a trade or business and owned by two individuals makes a payment of $1,000 to a qualified organization. In return for the payment, the S corporation receives or expects to receive a state tax credit equal to 80% of the amount of the payment. The tax credit is to be applied to local real property tax. Under applicable state and local law, the real property tax is imposed at the entity level (not the owner level).

How much of the payment can the S corporation deduct under the safe harbor?

or

***

Note: Taxing Lessons provides a summarized version of sometimes lengthy court decisions and IRS documents. The full documentation may include facts and issues not presented here. Please use the link provided in the post to read the entire document.

This information should not be considered legal, investment, or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment, or tax advice. Always consult your legal, investment, and/or tax advisor regarding your personal situation.

***

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✓ Right answer!
Yes, the corporation may treat the $1,000 payment as meeting the requirements of an ordinary and necessary business expense.
Sorry, wrong answer :(
✓ Right answer!

The corporation may treat $800 as meeting the requirements of an ordinary and necessary business expense under the safe harbor.

The treatment of the remaining $200 will depend on the facts and circumstances and is not affected by this revenue procedure.

Sorry, wrong answer :(

The corporation may treat $800 as meeting the requirements of an ordinary and necessary business expense under the safe harbor.

The treatment of the remaining $200 will depend on the facts and circumstances and is not affected by this revenue procedure.

✓ Right answer!

Yes, the pass-through company may treat the $1,000 payment as meeting the requirements of an ordinary and necessary business expense.

Sorry, wrong answer :(
✓ Right answer! The S corporation may treat $800 as meeting the requirements of an ordinary and necessary business expense under the safe harbor. The treatment of the remaining $200 will depend upon the facts and circumstances and is not affected by this revenue procedure.
Sorry, wrong answer :(
The S corporation may treat $800 as meeting the requirements of an ordinary and necessary business expense under the safe harbor.
The treatment of the remaining $200 will depend upon the facts and circumstances and is not affected by this revenue procedure.
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