Structuring advertising expenditures to avoid reclassification as charitable contributions.

For a business, advertising is essential. A marketing strategy is implemented through advertising programs, sales promotions and distribution programs. Advertising expense is an allowable deduction under Sec. 162(a). However, some advertising promotions may involve payments to charitable or civic organizations. Unless properly structured, these expenditures may be reclassified as charitable contributions and may be limited by Sec. 170(b), rather than being fully deductible under Sec. 162(a). This reclassification is particularly critical for businesses that anticipate losses or minimal amounts of income.

Limitation of deductions

Depending on the product or service offered, organizations that are listed in Sec. 170(c) (e.g., community chests, churches or schools) could be involved in marketing strategy. Sec. 162(b) specifically addresses the deduction of charitable contributions and gifts: "No deduction shall be allowed under subsection (a) for any contribution or gift which would be allowable as a deduction under section 170 were it not for the percentage limitations . . . . " As a further limitation, Regs. Sec. 1.162-15(a) states that "[n]o deduction is allowable under section 162(a) for a contribution or gift by an individual or a corporation if any part thereof is deductible under section 170." (Emphasis added.)

If a business is operated as a sole proprietorship or partnership, the charitable contribution is deductible by the taxpayer on Form 1040, Schedule A. These contributions are limited by Sec. 170(b)(1) to a percentage of the taxpayer's adjusted gross income (AGI) without consideration of net operating loss (NOL) carrybacks. A taxpayer operating a business with start-up losses must have another source of income resulting in positive AGI or the deduction will not be allowed.

If the business is operated as a corporation, the deduction is limited to 10% of taxable income without regard to the charitable deduction, NOL carrybacks, capital loss carrybacks and some special deductions.

For many businesses (regardless of form) these limitations are not a problem. However, for a business that incurs losses, Sec. 170(b) will eliminate a current charitable contribution deduction (although the deduction may be carried forward for five years).

Not all payments made to a charitable organization are gifts within the meaning of Sec. 170. The key to deductibility is to structure the payments made to the charity, school or civic group so that the amounts are not gifts, but rather an advertising expense fully deductible under Sec. 162(a).

Structuring advertising expenditures

Regs. Sec. 1.162-15(b) allows a deduction for expenditures made to Sec. 170(c) organizations if the taxpayer can show that the donations "bear a direct relationship to the taxpayer's business and are made with a reasonable expectation of a financial return commensurate with the amount of the donation. . . ." Regs. Sec. 1.162-20(a)(2) allows institutional or goodwill advertising to be deducted. In order to qualify for this deduction, the advertising must keep the taxpayer's name before the public and "the expenditures are related to the patronage the taxpayer might reasonably expect in the future." An example provided is the cost of advertising that encourages contributions to the Red Cross or the purchase of U.S. Savings Bonds.

In Old Mission Portland Cement Co., 293 US 289 (1934), the Supreme Court addressed the question of whether or not a contribution by a corporation to a community chest represented "consideration for a benefit flowing directly to the corporation as an incident of its business." The Court stated that it was a question of fact as to whether the corporation received benefit from the contribution and that the Service's ruling was presumably correct, thereby placing the burden of proof squarely on the taxpayer. The taxpayer asserted that the gifts resulted in goodwill and increased its business. Since there was no evidence presented to establish that a direct benefit existed, the Sec. 162(a) deduction was disallowed. (No charitable contribution deduction was available to corporations in 1939.)

In Minnesota Tribune Co., 103 F2d 947 (8th Cir. 1939), a newspaper made a donation of $208 to Minnesota College and deducted the amount under Sec. 162(a). The college was an advertising customer of the newspaper and the donation enabled the paper to retain this source of advertising income. The newspaper was able to substantiate the receipt of $444 in advertising revenue from the college and was allowed the deduction.

Rev. Rul. 63-73 allowed amounts paid by a corporation to a charitable organization for the use of the charity's name in the corporation's advertising program to be deducted under Sec. 162(a). In the agreement, the corporation paid the charitable organization a predetermined amount for each unit sold for which a label was mailed to the charity by the purchaser. In return, the charity agreed to permit the use of its name in connection with the advertising. The ruling stated that the obligation by the charity to permit its name to be used was sufficient consideration for the amounts received; as such, the payments were not in fact contributions or gifts within the meaning of Sec. 170.

Three situations involving parimutuel racetracks are relevant to the classification of expenditures. In Rev. Rul. 72-542, a racetrack donated the proceeds from a charity day to a local foundation that qualified as a Sec. 170(c) organization. There was no expectation of economic return; therefore, the amount donated was not deductible as an ordinary and necessary business expense under Sec. 162(a). However, the ruling made the point that a deduction under Sec. 170 was still available to the taxpayer, subject to the limitations therein.

In Pensacola Greyhound Racing, Inc., TC Memo 1973-225, the American Greyhound Track Operators Association made a pledge to the Miami Beach Chamber of Commerce to help Florida attract the Republican National Convention. An assessment was made against each member track, and Pensacola Greyhound mailed its assessment to the Miami Chamber of Commerce, taking a deduction as an ordinary and necessary business expense. The court found no direct connection between the Miami Chamber of Commerce, 650 miles away, and the Pensacola racing activities and disallowed the Sec. 162(a) deduction. (There was no indication that the taxpayer chose to take a Sec. 170 deduction.)

In Rev. Rul. 77-124, a racetrack relied on a favorable vote of the citizens in the county in which the track was located to obtain a permit to operate the track. To influence the voters, the track designated charity days and donated all the receipts less operating expenses to support local charities.

Since the racetrack committed to hold specific charity days to obtain and ensure retention of its operating license, the payments bore a direct relationship to the taxpayer's business. The payments to local charities were made with reasonable expectation of financial return commensurate with the amount of the payments. Therefore, the payments were ordinary and necessary business expenses and not charitable donations subject to Sec. 170.

In IRS Letter Ruling (TAM) 8145020, a corporation engaged in newspaper publishing provided $110,000 a year for 10 years to fund a first grade reading program in the county. The benefits claimed by the corporation included (1) goodwill toward the taxpayer as a result of publicizing the payments, (2) improved employee morale and productivity as a result of pride in the employer, (3) increased circulation and advertising revenues by expanding literacy in the community and (4) new prospects for expansion through increased literacy, which would raise the area's standard of living.

The Service confirmed that the payments clearly were gifts within the meaning of Sec. 170. However, since the benefits were primarily indirect rather than direct, with no reasonable prospect of commensurate financial return, the payments were not deductible under Sec. 162(a).

In IRS Letter Ruling 9309006, a Sec. 162(a) deduction was allowed for a grocery store promotion that was a form of goodwill advertising. The retail store planned to allocate 1% of its annual sales to local charities. The store intended to advertise the program and to require charities receiving

donations to allow their names to be used in that advertising. The Service ruled that the payments qualified as goodwill advertising and "related to the patronage the taxpayer might reasonably expect in the future." Having met those two criteria, the payments were deemed deductible as ordinary and necessary business expenses.

Conclusion

A business may experience losses or minimal income at any time in its life. Regardless of the business's form, charitable donations may be limited by Sec. 170(b). However, all payments to Sec. 170(c) organizations need not be classified as charitable contributions and subject to those percentage limitations. The IRS recognizes that some expenditures are ordinary and necessary business expenses and fully deductible in the year paid.

In order to qualify for the Sec. 162(a) deduction, the payments must meet two criteria: (1) they must bear a direct relationship to the taxpayer's business and (2) they must be made with a reasonable expectation of financial return commensurate with the amount of the transfer. Both of these criteria are a question of fact and the burden of the proof is on the taxpayer.