Charitable contributions of inventory by C corporations.

C corporations are entitled to a deduction for charitable contributions; however, several limitations apply in determining the deductible amount. The principal restriction, found in Sec. 170(b)(2), is that the deduction for any tax year is limited to 10% of taxable income determined without regard to charitable contributions, special deductions (dividends received deduction, etc.) and net operating and capital loss carry-backs. Charitable contributions in any year are available as a carry-forward to the five successive taxable years. These excess contributions are subject to the same 10% limitation in subsequent years. Cash contributions are subject only to the 10% overall limitation. However, donations in the form of property are subject to additional limitations.

A general principle of charitable contributions is that the deduction for gifts of property other than money is based on the property's fair market value (FMV). Although not specifically mentioned in the law, Regs. Sec. 1.170A- 1(c) states that FMV is the starting point from which the deductible amount is determined after application of the various limitations.

General rule

Sec. 170(e)(1)(A) provides that the deductible amount of a contribution of property is reduced by "the amount of gain which would not have been long-term capital gain if the property contributed had been sold by the taxpayer at its f air market value (determined at the time of such contribution)...." Stated differently, the deduction is reduced to the extent that a sale of the property would have produced ordinary income or short-term capital gain. Thus, for contributions of inventory property the amount of the deduction is generally limited to the taxpayer's basis, except for certain qualified contributions under Sec. 170(e)(3).

The question of how the overall 10% of taxable income limitation interacts with a contribution of inventory property is somewhat answered by Regs. Sec. 1.170A-1(c)(4). The regulation splits donated inventory into two components based on the tax year acquired. Any costs and expenses pertaining to the contributed property which were incurred in taxable years preceding the year of contribution and are properly reflected in the opening inventory for the year of contribution must be removed from inventory and are not a part of the cost of goods sold for purposes of determining gross income for the year of contribution. Any costs and expenses pertaining to the contributed property which are incurred in the year of contribution and would, under the method of accounting used, be properly reflected in the cost of goods sold for such year are to be treated as part of the cost of goods sold for such year.

Thus, donated inventory items acquired in prior tax years are treated as charitable contributions subject to the overall 10% limitation, but the cost of inventory items acquired and donated in the same year are considered as part of cost of goods sold (and thus not subject to the limitation). This illogical result, for which there does not appear to be any policy rationale, has been confirmed in IRS Letter Ruling (TAM) 8008013: The five percent prior law] limitation of section 170(b)(2) ... does not apply to the deduction for cost of goods sold in a situation in which the property contributed was purchased in the same taxable year.

Therefore, it would appear that if a corporation is faced with the 10% limitation, due to a current year loss or otherwise, it may be preferable to abandon or otherwise dispose of inventory acquired in prior years rather than making a charitable contribution. Again, this result clearly makes no sense from a tax policy standpoint.

Special rule

Sec. 170(e)(3) provides for a special rule for contributions of inventory if certain conditions are met. 1. The property must be used by the donee in its exempt function and solely for the care of the ill, needy or infants. 2. The property must not be sold or exchanged by the donee. 3. The taxpayer must receive a written statement from the donee that the use and disposition of the property will be in accordance with conditions 1 and 2.

If these conditions are satisfied, the amount of the deductible contribution is the property's FMV reduced by (1) one-half of the gain that would be ordinary income if the property were sold for FMV on the date of the contribution, and (2) by an amount by which the allowable deduction remaining after the first reduction exceeds twice the taxpayer's basis in the property. Put another way, the taxpayer obtains relief from the general rule of Sec. 170(e)(1)(A) (which limits the amount of the deduction to cost), and the amount of the deduction is equal to the taxpayer's basis in the property plus one-half the unrealized appreciation, not to exceed twice the taxpayer's basis in the property.

This principle can be illustrated in the following examples. Example 1: Corporation X donates an item of inventory with an FMV of $900 and a basis of $200. The allowable deduction is $400, computed as follows.

FMV                               $900
Basis (a)                          200
Unrealized gain                    700
One-half of unrealized gain (b)    350
(a) + (b)                          550
Limit (twice the basis)           $400

Example 2: Assume the same facts as Example 1, except that the inventory's basis is $600. The allowable deduction would then be $750.

FMV                                $  900
Basis (a)                             600
Unrealized gain                       300
One-half of unrealized gain (b)       150
(a) + (b)                             750
Limit (twice the basis)            $1,200

Note: If the special rule for qualifying contributions under Sec. 170(e)[3) did not apply, the deduction would be limited to basis under the general rule of Sec. 170(e)(1).

Under Regs. Sec. 1.170A-4 A(c)(1), the computations used to determine the amount of the contribution must be made "before applying the percentage limitations under section 170(b)" (the 10% overall limitation). Therefore, it would appear that inventory contributions under the special rule are subject in full to the 10% limitation without regard to the period in which the contributed inventory was acquired. This is amplified by Regs. Sec. l.l70A-4A(c)(3), which provides that an adjustment must be made to cost of goods sold. The regulation states, "Notwithstanding the rules of [Regs. Sec.] 1.170A - 1(c)(4) [the bifurcation rule], the donor of property which is inventory ... must make a corresponding adjustment to cost of goods sold by decreasing the cost of goods sold by the lesser of the fair market value of the contributed item or the amount of basis ......"

By decreasing costs of goods sold in an amount equal to the lesser of FMV or basis, the total amount of the contribution (the basis as well as the incremental amount allowed) is subjected to the 10% overall limitation. The imposition of the 1 0% overall limitation in this situation is perhaps somewhat fairer, since the taxpayer is receiving an incremental deduction beyond cost. Nonetheless, it would seem that from a policy viewpoint the 10% limitation should apply only to the incremental deduction and not limit (or postpone) a deduction for cost.

Conclusion

As previously noted, an illogical result appears to occur in certain situations. For instance, if an item is in opening inventory and the special rule does not apply, abandoning or otherwise disposing of the item may be preferable if a charitable contribution deduction would be limited by the 10% limitation. The first question that must be asked is whether the inventory carrying value is proper. Taxpayers that use lower of cost or market in valuing their inventories may be able to take a partial or full writedown of the item prior to contribution. In that case the actual amount of the contribution may be nominal. Naturally, this type of analysis will not provide any benefit to a taxpayer attempting to claim an incremental deduction under the special rule, since, by definition, the inventory item donated must have incremental value.

The special rule providing the incremental deduction is technically not elective. However, from a practical standpoint, it can be. A corporation could, if it desires, fail the substantiation test by not receiving a written statement regarding the use of the property. This may offer some planning opportunities, especially in conjunction with the general rule's bifurcation provision.

The following points should be considered, depending on a corporation's situation in any given year. * Corporations should always attempt to qualify donations of items in opening inventory under the special rule, because under the general rule the 10% overall limitation will apply. Therefore, the incremental deduction of the special rule is an added benefit at no cost. * Contributions of items added to inventory in the current year should be made to qualify under the special rule if the 10% overall limitation will not pose a problem. If a limitation results, the corporation may want to have some or all of these donations not qualify for the special rule. By doing so, the company would receive a full deduction of this basis through the cost of goods sold. This strategy should be considered by corporations with relatively low taxable income or a loss for the year, especially if the loss can be carried back providing an immediate benefit. * Proper planning cannot be done for any single year in isolation. A corporation must consider the availability of excess contributions to reduce future taxable income. If the 10% limitation can be expected to apply in future years, building up large excess contributions may provide little or no benefit. in this situation, a strategy of maximizing the current deduction through costs of goods sold and avoiding the special rule may be beneficial.