Editor: Kevin D. Anderson, CPA, J.D.
Does a deduction that a business takes for charitable contributions reduce its qualified business income (QBI) for purposes of its Sec. 199A deduction? The question has arisen based on language in recent IRS guidance.
Late in 2019, the IRS released draft Forms 8995, Qualified Business Income Deduction Simplified Computation, and 8995-A, Qualified Business Income Deduction, and related instructions, and the Service has since finalized those forms. The forms are to be completed by individuals and eligible estates and trusts that have QBI, qualified real estate investment trust (REIT) dividends, or qualified publicly traded partnership (PTP) income or loss. Some welcomed the release of the 2019 forms and instructions with open arms because in 2018 taxpayers were left with uncertainty as to how best communicate their 2018 QBI deduction computation to the IRS.
Generally, the new forms replicate the process established for tax year 2018 in IRS Publication 535, Business Expenses. The components of the Form 8995-A and related schedules are almost identical to the worksheets in the 2018 Publication 535, while Form 8995 was designed for taxpayers who do not aggregate their trades or businesses or report specified service trades or businesses. With respect to the new forms' related instructions, however, the IRS has done some notable rewriting in comparison to the instructions provided in Publication 535 for 2018.
The updates to the instructions have not gone unnoticed in the practice community. Particularly, practitioners have homed in on the following excerpt from the current Form 8995 instructions:
To figure the total amount of QBI, you must consider all items that are related to the trade or business. This includes, but isn't limited to, charitable contributions, unreimbursed partnership expenses, business interest expense, deductible part of self-employment tax, self-employment health insurance deduction, and contributions to qualified retirement plans. [Emphasis added]
By comparison, Publication 535 for 2018 never specified charitable contributions, stating:
Your QBI includes items of income, gain, deduction, and loss from any trades or businesses (or aggregated trade or business) that are effectively connected with the conduct of a trade or business within the United States. This includes income from partnerships (other than PTPs), S corporations, sole proprietorships, and certain trusts that are included or allowed in determining your taxable income for the year. It also includes other deductions attributable to the trade or business including, but not limited to, deductible tax on self-employment income, self-employed health insurance, and contributions to qualified retirement plans.
Those familiar with the Sec. 199A statutory language and the final regulations will notice that the description provided in Publication 535 is truer to the source language. In particular, for the 2019 instructions to Forms 8995 and 8995-A, the IRS has added not only charitable contributions but also unreimbursed partnership expenses and business interest expense as items to be included in the calculation of QBI. By including them, the IRS is suggesting that these items are potentially attributable to a trade or business for purposes of Sec. 199A. The instructions to Form 1065, U.S. Return of Partnership Income, also explicitly mention the deduction for charitable contributions as an item that may be attributable to a trade or business and reduce QBI. This is a head-scratcher because these items are not discussed in Sec. 199A.
Likewise, in the preamble to the final regulations (T.D. 9847), Treasury and the IRS declined to address whether deductions for unreimbursed partnership expenses and the interest expense to acquire partnership and S corporation interests are attributable to a trade or business, "as such guidance is beyond the scope of these regulations." The preamble also states that whether a deduction is attributable to a trade or business must be determined under the section of the Code governing the deduction. Moving out of the preamble and into the regulations, one can see that unreimbursed partnership expenses and business interest expense receive no mention, consistent with the preamble discussion. Regs. Sec. 1.199A-3(b)(1)(vi) provides:
Generally, deductions attributable to a trade or business are taken into account for purposes of computing QBI to the extent that the requirements of section 199A and this section are otherwise satisfied. For purposes of section 199A only, deductions such as the deductible portion of the tax on self-employment income under section 164(f), the self-employed health insurance deduction under section 162(l), and the deduction for contributions to qualified retirement plans under section 404 are considered attributable to a trade or business to the extent that the individual's gross income from the trade or business is taken into account in calculating the allowable deduction, on a proportionate basis to the gross income received from the trade or business.
Receiving even less consideration in the final regulations are charitable contributions. A search of T.D. 9847 yields no discussion of whether the deduction for charitable contributions should be included in the computation of QBI.
Should the deduction for charitable contributions reduce QBI? It is necessary to review the guidance on the nature of charitable contributions to see if any parallels can be drawn that justify classifying the deduction as both a charitable contribution and attributable to a trade or business. The first step is to look to Sec. 170(c), which provides the definition of a charitable contribution. The term is defined as a contribution or gift to or for the use of a qualified charitable organization. What remains unclear is how this relates to a trade or business and if the payment could also be considered a trade or business expense. To answer this question, it is necessary to look to Regs. Sec. 1.162-15(a)(1), which provides that no deduction is allowable under Sec. 162(a) for a contribution or gift by an individual or a corporation if any part thereof is deductible under Sec. 170. Regs. Sec. 1.170A-1(c)(5) provides the parallel of this when it states that transfers of property to an organization described in Sec. 170(c) that bear a direct relationship to the taxpayer's trade or business, and that are made with a reasonable expectation of commensurate financial return, may constitute valid expenses of a trade or business, deductible under Sec. 162, rather than charitable contributions.
Next, the description of charitable contributions the IRS provides in Publication 535 provides additional clues:
Cash payments to an organization, charitable or otherwise, may be deductible as business expenses if the payments aren't charitable contributions or gifts and are directly related to your business. If the payments are charitable contributions or gifts, you can't deduct them as business expenses. However, corporations (other than S corporations) can deduct charitable contributions on their income tax returns, subject to limitations. See the Instructions for Form 1120 for more information. Sole proprietors, partners in a partnership, or shareholders in an S corporation may be able to deduct charitable contributions made by their business on Schedule A (Form 1040).
This description suggests that a payment is either a charitable contribution or a business expense. It is never both. The taxpayer does not have a choice in determining whether a payment is deductible as a charitable contribution or as an ordinary and necessary business expense. The deduction for charitable contributions is permitted by Sec. 170, whereas a deduction for business expenses is permitted under Sec. 162.
The decision in Brooks, 10 T.C.M. (CCH) 1094 (1951), said that a merely incidental benefit to the taxpayer's business resulting from a payment to a charity does not remove the payment from the gift or contribution category. Presumably, a more-than-incidental benefit to the taxpayer's business resulting from a payment to a charity would cause the expense to instead be deductible under Sec. 162. Recall that whether a deduction is attributable to a trade or business must be determined under the section of the Code governing the deduction. If it is determined that the amount paid is something other than a trade or business expense deductible under Sec. 162, then it is a stretch to assert that a true charitable contribution deductible under Sec. 170 is related to a trade or business for purposes of Sec. 199A.
Kevin D. Anderson, CPA, J.D., is a managing director, National Tax Office, with BDO USA LLP in Washington, D.C.
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