Charitable Contributions Now Excluded from Section 199A

The IRS recently revealed a subtle but major change under Section 199A with the release of 2020 draft instructions for Form 8995. It now appears that deductions for charitable contributions do not reduce qualified business income (QBI). This is a major change from previous guidance; however, it is unfortunate that this guidance comes so late in the 2019 compliance season, as taxpayers who made significant charitable contributions in 2019 may not be able to benefit.

What Changed: A Comparison of 2019 Instructions to 2020 Instructions

Clarifications regarding the charitable contributions/QBI issue are subtle. The 2019 Form 8995 instructions provided as follows on page 2:

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.

However, the 2020 draft Form 8995 instructions (as of October 9) omitted “charitable contributions” in this passage. A similar indication concerning charitable contributions appeared in the “Statement A” sample on page 50 of the 2019 Form 1065 instructions. The IRS made a corollary change to remove the “charitable contributions” line in the 2020 draft Form 1065 instructions. The IRS did not elaborate elsewhere in the 2020 draft instructions about the charitable contribution omission.

Exploring the Nuances of QBI and Charitable Deductions

The 2019 IRS guidance concerning the treatment of charitable contributions caught many taxpayers off guard. In March 2020, the AICPA recommended that the IRS change its position in the form instructions to conform with a position that charitable contributions are unrelated to the trade or business of a taxpayer.

The issue partly relates to whether a charitable contribution may be deductible under Section 170 or Section 162:

• A Section 170 charitable contribution exists when there is a voluntary and irrevocable transfer of money or property made under charitable intent without the receipt of adequate consideration or a substantial return benefit.
• A Section 162 deduction is permissible when a payment made to a charity with an expectation of a commensurate financial return that directly relates to the taxpayer’s trade or business. No deduction is allowable under Section 162 if the contribution is deductible under Section 170.

Assuming there is an IRC Section 170 charitable contribution, taxpayers must consider whether the charitable contribution is nevertheless “related to the trade or business,” which is a condition to determine whether that item is included as part of a taxpayer’s QBI. The 2018 proposed regulations for Section 199A first raised this issue by specifically listing charitable contributions as a form of QBI.

The IRS suggested in the 2018 proposed regulations that Section 170 charitable contributions were related to a trade or business; however, the context of this statement could also be interpreted to pertain only to effectively connected income rules for situations where an Section 162 business does not otherwise exist. In any case, the IRS did not restate this comment or elaborate further in the 2019 final Section 199A regulations.

Other Indicators of a Stance Change

There are signs that the IRS is drawing a clearer line about the charitable contribution QBI inclusion other than omitting the phrase in the draft instructions. More recently, the IRS made a significant statement concerning this question in CCA 202027003, noting:

A charitable contribution is, by its nature, not allocable to any source of income, but instead arises from a donor's charitable intent to voluntarily transfer money or property without receiving any benefit in return.

In CCA 202027003, the IRS sought to determine whether an Section 170 charitable contribution related to a charity’s exempt function income or instead to the charity’s unrelated business income. The IRS statement is significant because many believed that Section 170 charitable contributions relate to a trade or business when made out of that trade or business, even though they are not deductible under Section 162. The IRS position in CCA 202027003 runs contrary to that view, indicating that the IRS instead believes that Section 170 charitable contributions are not allocable to any particular source of income. Accordingly, they are not allocable to trade or business income, which is a prerequisite to treating an item as part of QBI.

Take Away

For now, the IRS change to the 2020 draft instructions most likely can be taken as a “green light” to begin excluding charitable contributions from the determination of QBI. This means that tax strategies are no longer necessary for certain closely held business (e.g., making distributions instead of charitable contributions, with owners each making subsequent charitable contributions personally). Because the change appears in draft instructions, we will need to monitor the final version of the instructions to ensure the IRS remains consistent with this change. Should you have additional questions regarding this change, please contact us.