Payments to charities by business enterprises: Sec. 162 vs. Sec. 170.

Whenever a business enterprise makes a payment to a charitable organization, it is often beneficial to ascertain whether the expense can be classified as an ordinary and necessary business expense (deductible under Sec. 162) rather than a charitable deduction (under Sec. 170).

While the proper classification could be beneficial for C corporations, it is frequently more important for S corporations, limited liability companies, partnerships and sole proprietorships. For many businesses not operating as C corporations, the tax deduction will ultimately be taken on individual income tax returns, where it is usually more advantageous to have a deduction in computing adjusted gross income (AGI) (Sec. 162) instead of a deduction from AGI (Sec. 170). This "above-the-line" deduction would be even more valuable to a taxpayer in states like New York, which reduces otherwise allowable itemized deductions of higher income taxpayers, or New Jersey, which provides no itemized deduction for charitable contributions.

Regs. Sec. 1.170A-1(c)(5) states that "[t]ransfers of property to [a charitable organization] which bear a direct relationship to the taxpayer's trade or business and which 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." It should be noted that Secs. 162 and 170 are mutually exclusive. An expense properly classified as a charitable deduction cannot be deducted as an ordinary and necessary business expense, even when part (or all) of the amount could not be deducted because of the charitable deduction percentage limitations, substantiation/appraisal requirements, or reductions for certain types of charitable contributions of property (Sec. 162(b)).

Whenever a business enterprise makes material payments to charitable or governmental entities, inquiries should be made to determine the motivation behind the payments. In many instances, the expectation of a financial return will be sufficiently direct to permit (or require) classification of the payment as an ordinary and necessary business expense. While such classification may not be beneficial in all cases, in many situations it will lower the business owners' tax liabilities.

Many types of charitable payments have been held to have a sufficiently direct relationship to an expectation of commensurate financial return so as to permit deduction as an ordinary and necessary business expense:

* Bargain sales of sewing machines by a sewing machine manufacturer to churches, schools and other charitable entities, in order to encourage training in the use of sewing machines and enlarge its future market (Singer Co., Ct. Cl., 1971).

* Payments by a travel agency to charitable organization clients when the payments were based on the amount, character and profitability of the business received and expected to be received (Marquis, 49 TC 695 (1968), acq. 1971-2 CB 3).

* Payments by a corporation to a charitable organization for cooperation and the use of its name in connection with the corporation's advertising program. Under the arrangement, the corporation paid the charity a specified amount on each unit of the corporation's product for which the purchaser mailed a label to the charity (Rev. Rul. 63-73).

* Payments made by the operator of parimutuel racetracks to local charities of profits earned on certain charity days, when the charity days were run to facilitate a favorable vote from the citizens in the area to enable the taxpayer to retain its racing license (Rev. Rul. 77-124; cf. Rev. Rul. 72-542).

* Payments by a stock brokerage business to a charitable organization equal to 6% of brokerage commissions received from the charitable organization, when the taxpayer advertised that it was making the payments to enable the charitable organization to reduce neighborhood tensions and combat community deterioration in the area in which the taxpayer's office was located. The taxpayer believed this advertised policy would promote new business and enable it to retain existing business (Rev. Rul. 72-314).

* Payments by a retail business in a resort city to a governmental oil pollution control fund used for research, beautification and advertising, in order to help recover tourist business lost due to oil pollution (Rev. Rul. 73-113).

* Payments by an employer corporation to a tax-exempt union educational and cultural charitable trust, when the payments were required pursuant to a collective bargaining agreement (Rev. Rul. 74-51).

* Contributions to a tax-exempt dance company in financial difficulty, when the taxpayer derived substantial income from performing services for the dance company (Letter Ruling 9045015).

* Payments by a supermarket business of 1% of its sales to various civic organizations, churches, government entities and charities located in the communities where stores were located, pursuant to a program of advertising the donation program in newspapers and on radio and television. The charities were required to agree to the use of the charity's name in connection with the advertising (Letter Ruling 9309006).

It should be noted that, when payments by a business enterprise to a charitable organization are held not to be charitable contributions under Sec. 170 because of their business connection, the expenditure may have to be capitalized. For example, a farmer who made a payment of a pledge to a county government that was conditioned on the paving of roads near the taxpayer's property was not allowed a charitable deduction and the taxpayer was required to capitalize the payment as an addition to the basis of his farm (Rev. Rul. 76-257).