Recently the IRS released final regulations updating guidance on payments to qualified charitable organizations to determine if the amounts are an ‘ordinary and necessary business expense’ or a ‘charitable contribution.’ The regulation provides a payment, which bears a direct relationship to the taxpayer’s trade or business, and is made with a reasonable expectation of financial return commensurate with the amount of the payment, may constitute an allowable deduction as a trade or business expense rather than a charitable contribution deduction.

Why does the categorization between business expense vs. charitable contribution matter? A business expense reduces ordinary business income, whereas a charitable contribution deduction is reported separately and subject to various restrictions.

A few of the benefits when classifying the payments as a business expense are as follows:

• There is no need for an individual to itemize deductions to obtain a tax benefit. For example, a charitable contribution received by an individual taxpayer from a pass-through entity is added to their contributions included in itemized deductions on their 1040. If the individual taxpayer does not have enough itemized deductions, the taxpayer will most likely use the standard deduction and lose the benefit of the charitable contribution from the pass-through entity. However, in Arizona, all is not lost since 25% of the charitable contribution is added to the AZ standard deduction if the taxpayer does not itemize for AZ filing purposes.
• The deduction reduces a taxpayer’s adjusted gross income (AGI) as an above-the-line deduction, rather than included in itemized deductions used to decrease taxable income. For other tax calculations that depend on AGI as a phaseout limit or maximum income amount, an above the line deduction helps to reduce said AGI.
• In some cases, charitable contribution deductions are subject to a percentage of AGI or taxable income (C corporation), whereas a business expense is not.

As a requirement, the business must be able to show two things when categorizing a payment to a qualified charitable organization as a business expense:

1. A direct relationship of the payment to the taxpayer’s trade or business and
2. The payment is made with a reasonable expectation of a financial return commensurate with the amount of the payment.

For example, a business that manufactures musical instruments and sells them through a website makes a $1,000 payment to a local church (a qualified charitable organization) for a half-page advertisement in the recital program for attendees at an upcoming choir performance. The business reasonably expects the advertisement will attract new customers to its website and increase sales. Under this example, the business may treat this payment as an expense of carrying on a trade or business.

We suggest double-checking your business’ bookkeeping procedures to ensure you are correctly categorizing these types of payments. As always, if you have further questions, please reach out to your tax preparer for more information.