New Rules for Donors to State Credit Funds
In August 2020 the IRS issued final regulations on the state and local payments made to charitable entities that are designed to limit workarounds with respect to the limitation on the deduction of state and local taxes. This changes how payments to state credit funds are handled for income tax purposes. Here is an overview of those changes and how they can affect you and your business.
Flow-thru entities and their owners are now held to a higher standard
C-Corporations and pass-through entities making payments to qualifying organizations, such as Alabama and Georgia scholarship organizations or Georgia rural hospitals can now claim a federal ordinary and necessary business expense deduction instead of a charitable contribution deduction.
The payment must bear a direct relationship to your trade or business, with the additional requirement that the payment was made with a reasonable expectation of financial return commensurate with the amount of the payment. For a pass-through entity, this means the owners could possibly receive both a federal business deduction and a state credit. There will be a similar result for C-Corporations; a federal ordinary and necessary business expense and a state income tax credit. It should be noted that you have to add back your federal deduction to your Georgia return. And in Alabama, no deduction is allowed.
It will be prudent to document the direct relationship and expectation of financial return when making a payment. For business owners, this is a higher standard than for substantiating a charitable contribution deduction. IRS regulations contain examples and other guidance.
Claiming donations as ordinary and necessary business expenses.
A partnership engaged in the health industry decides it will contribute to the Georgia Rural Hospital Program. The partners in the partnership reasonably believe that the contribution will generate name recognition, community goodwill and increase its revenue through referrals. The partnership may want to consider treating the payment as an ordinary and necessary business expense.
Separately, some or all the partners in the partnership may apply, fund and receive a Georgia income tax credit under the Rural Hospital Program. Any ordinary and necessary business expense deducted on a federal tax return would be added back to Georgia taxable income.
A real estate partnership that owns an apartment complex near a private school decides it will contribute to a state scholarship program and will direct its contribution to the private school. The partners reasonably believe that the publicity associated with the payment will provide name recognition and increase revenue from teachers and parents of students wanting to live near the school.
The partnership may want to consider treating the payment as an ordinary and necessary business expense. Separately, some or all the partners in the partnership may apply, fund and receive a Georgia income tax credit under the scholarship program. Any ordinary and necessary business expense deducted on a federal tax return would be added back to Georgia taxable income.
Individuals may get a tax deduction
For individuals contributing to the Alabama and Georgia scholarship and the Georgia rural hospital programs, this means a payment to these funds will be treated as a tax credit for state income tax purposes. However, a charitable contribution deduction will not be allowed.
Instead for an individual that itemizes deductions, a state and local tax deduction is permitted. Note that the itemized deduction for taxes is limited to $10,000 for most individuals. That means the tax payments above the dollar threshold are not deductible.
This treatment is allowed in the year the payment is made to the extent that the tax credit is utilized against the individual’s state income tax liability. Amounts not fully utilized against the state tax liability are treated as a tax deduction in the year the credit carryforward is utilized. See examples one and two below.
How individuals can apply contributions
An individual makes a payment of $1,000 to a qualifying state scholarship fund and receives a dollar for dollar state income tax credit. The individual utilizes the entire credit against her state tax liability. She may want to consider treating the payment as a state income tax deduction in the year paid, subject to the limit on itemized state tax deductions on her federal and state income tax returns.
The facts are the same as example 1, except that the individual’s state income tax liability is $750. In the year of payment, she may deduct $750 as a state income tax payment subject to limit on tax deductions on her federal and state income tax returns.
As the credit has a 5-year carryover, the individual may want to consider taking a tax deduction for the remaining $250 when the carryover credit is utilized.
An individual operates a personal financial planning practice as a single-member LLC. He would like to increase his medical professional clientele. To enhance name recognition and goodwill, he contributes to the Georgia Rural Hospital Fund in the name of his business with the expectation of generating additional medical professional clients.
The individual may want to consider treating the payment(s) as an ordinary and necessary business expense on Schedule C and claim the Georgia tax credit on his state income tax return subject to the limitations associated with the Georgia tax credit rules. Further, the business expense claimed on the federal return for the payment to the Georgia fund will be an add-back for Georgia income tax purposes.
Charitable Organization Reporting Requirements
As discussed above there are multiple ways persons and entities might classify these payments for tax purposes. Donors may not have determined how they might treat the payment at the time they fund it.
Therefore, a charitable organization may not want to monitor the tax position of its’ donors. It seems appropriate for these organizations to continue following the federal guidelines on issuing donation support and state guidelines to provide the proper tax credit documents to taxpayers.
The bottom line
These final regulations on payments made to charitable entities are designed to limit workarounds on state and local tax deductions. Determining how you should apply your payments to charitable entities to receive to maximize your tax benefit is complex.
If you, your business, or your charitable organization would like more information about the opportunities and pitfalls related to this matter contact one of our Aprio advisors.
Businesses and individual advice contact Frank Ciaburri.
Charitable and non-profit organizations contact Melisa Beauchamp.
Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding this matter.