Expenses & Deductions
In normal circumstances, donating qualifying food inventory can result in a charitable contribution deduction greater than the tax basis of the food inventory (Sec. 170(e)(3)), which gives taxpayers an additional incentive to make the donation. However, donations of “off-spec” food may not provide that same advantage because of the difficulty of determining the proper tax basis and fair market value (FMV) for the food. “Off-spec” food is food that does not meet specified or standard requirements set by the manufacturer. It often includes benign deviations that do not affect consumption of the food.
Large food manufacturers in the United States produce tons of off-spec food byproducts and joint products that are perfectly healthy and nourishing for hungry individuals to consume, but nonetheless end up in city dumps. Consider the example of a food manufacturer that produces two types of peanut butter, chunky and creamy, on the same production line. When the food manufacturer changes over the production line from chunky to creamy, or vice versa, the result can be several hundred pounds of inconsistently chunky peanut butter that the manufacturer does not generally sell in the marketplace. Even though the partially chunky peanut butter is perfectly healthy, it may be dumped to avoid any possible brand damage from an off-spec product.
Under current law, the ability to obtain an increased deduction over tax basis for the donation of off-spec food can be challenging because the food must meet the same tax requirements as other food; that is, it must constitute inventory for tax purposes and have a supportable FMV above tax basis. Unfortunately, a manufacturer that throws away off-spec food often receives the same deduction as a manufacturer that donates the food to a qualified charity (i.e., recovery of the costs associated with the food products). In fact, the manufacturer making the donation may incur additional processing and packaging costs to get food joint products and byproducts into a condition where they can be donated, yet the enhanced deduction may not be allowed for these products or the additional costs.
Sec. 170 provides a deduction for charitable contributions made to qualified charitable organizations. As a general rule, Regs. Sec. 1.170A-1(c) provides that the amount of the deduction for a charitable contribution of property other than money is equal to the FMV of the property. However, Sec. 170(e)(1) provides that a charitable contribution deduction generally is reduced by the amount of ordinary income that would have resulted had the contributed property been sold at its FMV at the time of contribution. Ordinary income, under Regs. Sec. 1.170A-4(b)(1), is any portion of the gain that would not have been long-term capital gain if the property had been sold by the donor at its FMV at the time of the charitable contribution. Because the gain realized from the sale of inventory is considered ordinary income, Sec. 170(e)(1) generally limits the deduction for charitable contributions of inventory with an FMV above tax basis to the donor’s tax basis in the inventory.
Despite the Sec. 170(e)(1) limitation, certain contributions of inventory are eligible for an enhanced deduction greater than tax basis under Sec. 170(e)(3). Sec. 170(e)(3) provides for a two-step limitation to the amount of the deduction for a charitable contribution in lieu of the general Sec. 170(e)(1) limitation. The amount of the first limitation under Sec. 170(e)(3) is equal to one-half the amount of the ordinary income gain that would have been realized on the inventory if it had been sold by the donor at the inventory’s FMV.
The second limitation under Sec. 170(e)(3) applies if the amount of the charitable contribution deduction otherwise remaining after the first step exceeds twice the tax basis of the contributed property, in which case the enhanced charitable deduction is limited to twice the tax basis of the contributed inventory. Put more simply, the enhanced deduction under Sec. 170(e)(3) is equal to the lesser of (1) the contributed inventory’s tax basis plus half of the ordinary income gain that would have been recognized had the inventory been sold or (2) twice the tax basis of the contributed inventory.
To qualify for the enhanced deduction under Sec. 170(e)(3), food must otherwise be held primarily for sale in the ordinary course of the taxpayer’s trade or business and have a supportable FMV and tax basis. In practice, deriving a supportable FMV and tax basis for off-spec food products can be difficult and overly burdensome for many taxpayers.
Putting aside the question of whether a particular off-spec food product can be characterized as inventory for tax purposes, Sec. 170(e)(3) and the regulations thereunder are silent about how taxpayers should determine tax basis of food, except that the donor must use as the basis of the contributed item the inventoriable carrying cost assigned to any similar item not included in closing inventory (see Regs. Sec. 1.170A-4A(c)(2)). It is not clear how this standard applies in situations where, as noted above, the manufacturer does not generally sell the off-spec item in the marketplace.
There is, however, other regulatory guidance addressing the question of how to determine tax basis when a single manufacturing process results in joint products or multiple byproducts. For situations where a taxpayer manufactures two or more products of varying kinds or grades in the same manufacturing process, two alternative cost allocation methods may be available. The first method, the joint product costing method, is provided by Regs. Sec. 1.471-7, which states that when a taxpayer engaged in manufacturing through a single process or uniform series of processes derives a product of two or more kinds, sizes, or grades, the unit cost of which is substantially alike, and that in conformity to a recognized trade practice allocates an amount of cost to each kind, size, or grade of product, which in the aggregate will absorb the total cost of production, the taxpayer may (with the consent of the IRS) use this allocated cost as a basis for pricing inventories, so long as the allocation bears a reasonable relation to the respective selling values of the different kinds, sizes, or grades of product (see, e.g., Technical Advice Memorandum (TAM) 200029011).
The second method, byproduct costing, is an allocation method under Sec. 263A to be used in situations where there is a significant disparity between the value of the main product intended to be produced and other products that are incidental to the main product (see, e.g., TAM 200437034). In practice, the byproduct costing method is often approached in two ways. The first approach allocates all of the acquisition and production costs to the main product and then credits revenues from the sale of the byproduct against the inventory cost of the main product. The second approach assigns byproducts a cost equal to sales values, so any gain that may result from the sales of the byproducts is effectively allocated to the sales of the main product.
Both the joint product costing method and the byproduct costing method depend on the manufacturer’s ability to sell the joint products or byproducts in the marketplace in order to assign them a tax basis. When a particular food item is not regularly sold in the marketplace, as in the case of the inconsistently chunky peanut butter discussed above, it becomes very difficult for taxpayers to establish a tax basis for the item under the joint product costing method or the byproduct costing method.
Fair Market Value
Regs. Sec. 1.170A-1(c)(2) provides that, in the case of inventory that is sold in the regular course of a taxpayer’s business, the FMV is the price that the taxpayer would have received if the taxpayer had sold the contributed property in the usual market. However, Regs. Sec. 1.170A-1(c)(3) provides that, if the donor makes a charitable contribution of property at a time when it could not reasonably have expected to realize its usual selling price, the value of the contribution is the amount for which the property could have been sold at the time of contribution and not the usual selling price. For food products that do not have a usual selling price (again, as in the case of the inconsistently chunky peanut butter), the FMV can be difficult to determine.
To qualify for the enhanced deduction under Sec. 170(e)(3), donated inventory must have a supportable tax basis (otherwise, twice zero tax basis is still zero) and a supportable FMV above the tax basis. However, existing methods that assign tax basis to joint products and byproducts, and the standards for determining the FMV for those products are premised on the taxpayer’s being able to demonstrate established sales or an apparent ability to sell the products in the marketplace at the time of donation. As a consequence, for food products that are not regularly sold in the marketplace, there may not be a tax incentive under Sec. 170(e)(3) for food manufacturers to donate the products rather than simply throw them away.
Consistent with the objective underlying Sec. 170(e)(3)(C), which Congress recently extended for another two-year period (American Taxpayer Relief Act, P.L. 112-240, §314), to encourage donations of food products that may deviate in appearance from items customarily sold in the marketplace, the government should consider providing guidance (perhaps a safe-harbor method to allocate tax basis and assign FMV) to off-spec food products so that the enhanced charitable deduction can be available in practice. Such guidance could ensure that more nourishing food ends up in the mouths of hungry individuals around the world, rather than in city dumps. Until such guidance is released, taxpayers that want to donate off-spec food products will continue to face challenges when attempting to quantify the charitable contribution deductions they may claim.
Jon Almeras is a tax manager with Deloitte Tax LLP in Washington, D.C.
For additional information about these items, contact Mr. Almeras at 202-758-1437 or email@example.com.
Unless otherwise noted, contributors are members of or associated with Deloitte Tax LLP.