How to deduct Charitable Contributions

One of the most popular deductions for taxpayers is the one allowed for donations to charitable organizations—from the local church or synagogue to the Red Cross and various other national organizations. Unfortunately, over the last several decades, this deduction has been among the most abused. Thus, perhaps it’s not surprising that Congress has responded to the problem by regularly enacting more rules around documenting donations.

What we’re left with is a confusing array of rules that you have to comply with in order to claim a deduction. A recent Tax Court case illustrates how easy it is to run afoul of the documentation requirements.

In the case, a partnership purchased a remainder interest in a web hosting facility for $2.95 million. The following year, it assigned the remainder interest to the University of Michigan. On its federal income tax return, the partnership claimed a charitable contribution deduction of approximately $33 million. Because the value of the donated property exceeded $5,000, the partnership got a formal appraisal and filed Form 8283 (Noncash Charitable Contributions) with its return. However, the space on the form was left blank for the partnership’s cost or other adjusted basis of the remainder interest.

Upon audit of the partnership, the IRS disallowed the charitable contribution deduction. It claimed the partnership had failed to comply with the substantiation requirements because it omitted a key part of Form 8283. The partnership, however, argued that it had substantially complied with the regulations. The Tax Court sided with the IRS, finding that the partnership’s omission of the basis amount prevented the appraisal summary from achieving its intended purpose. In other words, if the partnership had disclosed its basis in the remainder interest, the IRS would have seen the huge disparity between the amount of the deduction and the price the partnership had paid for the property.

While this letter has given you just a glimpse at the substantiation rules for charitable donations, the rules can get much more complicated. This is because the requirements vary based on donation type (cash versus property) and the value of the property contributed. We’d be happy to discuss with you any of the requirements for specific types of donations. Please feel free to call us as the need arises.

Switch from C Corp to S Corp? Part 2

You should be aware that if your corporation has any “earnings and profits,” then, even if it elects S corporation status, it may be subject to a corporate‐level tax on its passive investment income.

This tax would apply in any year the S corporation’s passive investment income exceeds 25% of its gross receipts. If that happens, the net passive income (after applicable deductions) that exceeds 25% of gross receipts is taxed at the highest corporate tax rate (currently 35%). Thus, a corporation that has (for the sake of simplicity) $100,000 of passive investment income and no other income or deductions would pay a tax of $26,250, i.e., 35% of $75,000 (the excess of $100,000 gross receipts over 25% of $100,000).

The tax reduces the amount of income passed through by the S corporation to the shareholders. Thus, in the above example, the S corporation would pass through income of only $73,750 ($100,000 minus the $26,250 of tax) rather than $100,000. However, there would still be double taxation since a tax was imposed at the corporate level. In addition, if the tax applies for three consecutive years, the corporation’s S election will terminate.

Since even the smallest amount of accumulated earnings and profits from C corporation years will subject an S corporation to a potential passive investment income tax, it is important to know (1) whether the corporation has any accumulated earnings and profits and, if so, (2) exactly how much the corporation has because the corporation can eliminate its tax risk completely by distributing all the earnings and profits. We can help you determine this.

Passive investment income generally includes non‐business related items such as dividends, interest, rents, and royalties. Passive investment income does not include dividends received from an 80%‐or‐more owned C corporation subsidiary when those dividends are generated by the C corporation’s active conduct of a trade or business. Gross receipts generally includes all amounts realized by the corporation, without reduction for cost of goods sold, returns, allowances, or other deductions.

You can avoid the tax by either (1) eliminating the accumulated earnings and profits from C corporation years, or (2) limiting the corporation’s passive investment income to 25% or less of its gross receipts.

For example, you can avoid any risk of the tax by having the corporation make an actual or deemed distribution of its accumulated earnings and profits from C corporation years before the end of the first S corporation tax year. The distribution will be treated as qualified dividend, taxable at a maximum rate of 20%. However, depending on the recipient’s adjusted gross income, the dividend also may be subject to the 3.8% net investment income tax.

If a distribution would mean too much tax to the shareholders, you can still elect S corporation status and avoid the passive investment income tax, as long as the passive income does not exceed 25% of the corporation’s gross receipts. If you decide to elect S status, but not to distribute the corporation’s accumulated earnings and profits from C corporation years, you would have to carefully watch the corporation’s future income to be sure that it does not exceed the 25%‐of‐gross‐receipts threshold. We can work with you to develop strategies to reduce the passive investment income and/or increase the corporation’s nonpassive income.