In August, the U.S. Treasury Department and the Internal Revenue Service issued final regulations on the deductibility of payments of cash or in-kind donations to certain tax-exempt organizations if the donor receives in return some form of consideration, e.g., state or local tax credits. The regulations are now effective but can be applied retroactively as well, if the taxpayer so elects, to “qualifying payments” made on or after January 1, 2018. The final regulations offered both good news and bad news for Alabama taxpayers and Alabama Scholarship-Granting Organizations (SGOs).
First, the final regs adopted the safe harbor in the proposed regs regarding donations by either taxable “C” corporations or “specified PTEs” to qualified organizations if in return the donor receives or expects to receive a credit against a state or local tax imposed on the entity itself, e.g., a property tax or sales or excise tax. Because the tax credit reduces the donor’s respective tax obligation on a dollar-for-dollar basis, the required business purpose for the donation is assumed. The donor should therefore be entitled to deduct the donation for federal income tax purposes as a “trade or business expense” under IRC section 162 (rather than as a charitable contribution), with little question from the IRS as to motive. We nevertheless recommend contemporaneous documentation of a non-tax business purpose for the donation.
Second, the final regs also adopt the proposed guidelines for donations by a pass-through entity (PTE) if in return it receives or expects to receive a state or local income tax credit, even if that credit flows through to the PTE’s owners as such (as well as the federal tax deduction). This provision is, of course, more relevant to donors in Alabama since only a state income tax credit is granted under the Alabama Accountability Act in return for a qualified donation. The final version requires the payment to (1) have a “direct business relationship to the trade or business” of the donor, and (2) be made with “a reasonable expectation of financial return commensurate with the amount paid” (Final Treas. Reg. § 1.162-15(a)). If so (and if well-documented), the payment is deductible under IRC section 162 as a business expense, rather than as a charitable contribution.
Thus, there is now clear and final guidance for both corporate and PTE donors to follow in making cash donations to worthy SGOs operating in the state of Alabama, which may entitle the owners of donor PTEs (a) to deduct their distributive share of the PTE’s donation as a business expense on federal Schedule E and (b) to claim their distributive share of the Alabama income tax credit as well (currently, through Alabama Schedules K-1 and AATC). However, the PTE must pre-register the donation on the Alabama Department of Revenue’s “My Alabama Taxes” (MAT) website, and there is an extra step imposed now. [This contrasts with the IRS’s restrictions on individual donors, who must elect to either claim only the state income tax credit or to waive the credit and simply deduct the donation for both federal and Alabama tax purposes, with limited exceptions.]
We recently spoke with Andrew Ryan, Executive Director of the Alabama Opportunity Scholarship Fund (a qualifying SGO), who focused on the hardships facing many scholarship families and encouraging donors to make a contribution before year-end. According to Ryan, “This has been a hard year for fundraising, but it’s been especially hard for our low income families on scholarship. They need this opportunity for their kids more than ever. We have hundreds of kids who still need their tax credit scholarships covered for this year.” Ryan stressed that individual and business taxpayers can help by donating an amount equal to a percentage of their Alabama income tax liability to the Alabama Opportunity Scholarship Fund before December 31. As noted above, taxpayers must pre-register their donations with the Alabama Department of Revenue, using the department’s MAT website.
The favorable rules apply to payments made to qualifying exempt organizations on or after December 17, 2019 (the effective date of the proposed regs). However, taxpayer may elect to have them apply to qualifying payments made after January 1, 2018.
