IRS advises on interaction of corporate charitable deductions and NOLs

Code Sec. 170(a) allows a deduction for charitable contributions paid within the tax year. Code Sec. 170(b)(2)(A) limits a corporation’s current charitable contribution deduction to 10% of its taxable income (the 10% limit).

Code Sec. 172(a) allows a deduction for any NOLs carried back and carried over to a tax year.

Taxable income is computed for purposes of the 10% limit without regard to the charitable contribution deduction or any NOL carryback to the tax year. But NOL carryovers are taken into account when calculating taxable income for purposes of determining the 10% limit. (Code Sec. 170(b)(2))

If a carryover of charitable contributions that a corporation makes in a tax year exceeds the 10% limit, then, in determining which charitable contributions are deductible in that tax year, current year contributions are deducted first. If current year contributions are less than the 10% limit, carryover contributions are taken into account in the order in which they arose. The maximum carryover period for charitable contributions is five tax years. (Code Sec. 170(d)(2)(A))

An NOL is carried to the earliest year available. Once carried to the earliest tax year available, all or a portion of the NOL is used up or absorbed. If an NOL carried to a tax year is more than the modified taxable income for the tax year, the excess of the NOL over the modified taxable income is carried to the next tax year. (Code Sec. 172(b)(2))

Modified taxable income is determined without taking into account the NOL to be absorbed or NOLs incurred in tax years that are after the tax year of the NOL to be absorbed. (Code Sec. 172(b)(2); Reg. §1.172-5(a)(2)(i)). IRS notes that NOLs carried from years before the tax year of the NOL to be absorbed are considered in determining modified taxable income, as are charitable contribution deductions.

IRS points out that, as a result of these provisions, more charitable contributions may be allowable in computing modified taxable income under Code Sec. 172(b)(2) than are allowable in computing taxable income under Code Sec. 170(b)(2). By reducing modified taxable income, these charitable contributions result in less NOL being absorbed than the actual amount of NOL used to reduce taxable income. Thus, the additional charitable contributions allowed in determining modified taxable income increase the amount of NOL carryovers to a subsequent taxable year.

IRS also points out that the additional charitable contributions that are allowed in computing modified taxable income are not actually deducted when a taxpayer computes taxable income. If these additional amounts were allowed as charitable carryovers, then the contributions would produce a double tax benefit (1) by reducing the amount of the NOL absorbed (which increases the NOL carryover) and (2) by remaining available in a subsequent tax year as a charitable contribution deduction.

IRS says Code Sec. 170(d)(2)(B) exists to prevent this result. Charitable carryovers must be reduced to the extent that an excess charitable contribution reduces modified taxable income in the absorption calculation of Code Sec. 172(b)(2) and increases an NOL carryover to a succeeding year under Code Sec. 172 (the Code Sec. 170(d)(2)(B) adjustment). (Code Sec. 170(d)(2)(B)) The effect of this is that some charitable contributions with a five-year carryover period are converted into an NOL with a twenty-year carryover period.

Rev Rul 76-145, 1976-1 CB 68, provides that, in computing its NOL carryover to the following year, a corporation is required to take into account charitable contributions carried over from the preceding year and combine them with the charitable contributions actually made during the current year. However, the contributions so taken into account cannot be carried over to the following year since they served to reduce the taxable income for the current year and thereby increased the NOL carryover.

Facts. Taxpayer was a corporation that had several years of NOL carryovers and charitable contribution carryovers (charitable carryovers) that were available to use in Year 2, the year at issue. The NOL carryovers totaled Amount 1 and the charitable carryovers totaled Amount 2. The charitable carryovers included Amount 3 from Year 1, which had not been utilized for four consecutive years and was scheduled to expire at the end of Year 2 if not utilized.

In Year 2, Taxpayer generated taxable income of Amount 4 before considering its NOL carryovers. Also in Year 2, Taxpayer made charitable contributions of Amount 5. All of Taxpayer’s Year 2 taxable income was offset by its NOL carryovers reducing its taxable income to zero. As a result, Taxpayer was not allowed to deduct any charitable contributions in Year 2. Taxpayer had additional unused NOL and charitable carryovers available for use in the following year, Year 3.

Issue 1. IRS examiners asserted that the Code Sec. 170(d)(2)(B) adjustment must be calculated for each tax year an NOL carryover is absorbed, beginning with the earliest NOL available for use in the tax year. So, the examiners applied the 10% limit to Amount 6 (Amount 4 less the Year 4 amount of Amount 7). Ten percent of Amount 6 equaled Amount 8.

Taxpayer’s position was that the Code Sec. 170(d)(2)(B) adjustment should be calculated on an aggregate basis. As a result, Taxpayer did not apply the Code Sec. 170(d)(2)(B) adjustment on a year-by-year basis. It applied the 10% limit to the Year 2 taxable income of Amount 4, which equaled Amount 9. Amount 9 was greater than Amount 8, and under Taxpayer’s method, it would be entitled to a larger Code Sec. 170(d)(2)(B) adjustment than allowed by the IRS.

Issue 2. Taxpayer and the examiners disagreed on which charitable contributions must be reduced pursuant to the Code Sec. 170(d)(2)(B) adjustment. The examiners asserted that Taxpayer must first reduce the Year 2 charitable contributions by the Code Sec. 170(d)(2)(B) adjustment. If a Code Sec. 170(d)(2)(B) adjustment remained after reducing the Year 2 charitable contributions to zero, then Taxpayer would reduce its charitable carryovers starting with the earliest year.

In this case, the Year 2 charitable contributions of Amount 5 were greater than the Code Sec. 170(d)(2)(B) adjustment, so no charitable carryovers are taken into account in computing the Code Sec. 170(d)(2)(B) adjustment.

Taxpayer contended that Code Sec. 170(d)(2)(B) does not address which charitable contributions must be reduced first so it should be able to use any reasonable method. Thus, in computing the Code Sec. 170(d)(2)(B) adjustment, Taxpayer reduced its expiring charitable carryovers from Year 1 rather than the charitable contributions made in Year 2.

Taxpayer also cited Rev Rul 76-145 for the proposition that current year charitable contributions and all charitable carryovers are co-equal, fungible elements of “excess contributions,” and each is an equally viable option to be reduced first or last.

IRS ruling on issue 1. IRS ruled that Code Sec. 172(b)(2) requires a chronological, year-by-year, NOL absorption computation to determine the charitable contribution carryover adjustment under Code Sec. 170(d)(2)(B).

Applying an aggregate basis standard is incorrect. In determining modified taxable income, Taxpayer was required to take into account the Year 4 NOL carryover of Amount 7. The NOL to be absorbed (part of the Year 5 NOL carryover) is not taken into account in determining modified taxable income.

Accordingly, the Code Sec. 170(d)(2)(B) adjustment is Amount 8.

IRS ruling on issue 2. The Year 2 charitable contributions must be reduced first. In addition, the rules of Code Sec. 170 and Code Sec. 172, which must be read in conjunction, dictate that current year charitable contributions rather than charitable carryovers are taken into account in the Code Sec. 172(b)(2) calculation that reduces modified taxable income and increases the NOL carryover.

As a result, IRS ruled that it is the current year charitable contributions that trigger the Code Sec. 170(d)(2)(B) adjustment and must therefore be reduced before reducing its earliest year’s charitable contribution carryover.

In Rev Rul 76-145, the current year charitable contributions were $2, but the applicable percentage limit was $5. Thus, the current year charitable contributions of $2 plus the charitable carryover of $3, together, had to be taken into account in calculating the Code Sec. 170(d)(2)(B) adjustment because the $2 and the $3, together, reduced modified taxable income in the absorption calculation of Code Sec. 172(b)(2) and increased the NOL carryover to a succeeding year under Code Sec. 172. If the current year charitable contributions were also $3, then the current year charitable contributions would be reduced first by operation of Code Sec. 170(d)(2)(B), and there would be $1 left of the charitable carryover.

In Taxpayer’s case, the Year 2 charitable contributions of Amount 5 were greater than the 10% limit of Amount 8. Thus, only the Year 2 charitable contributions of Amount 5 were taken into account in calculating the Code Sec. 170(d)(2)(B) adjustment because Amount 5 alone reduced modified taxable income in the Code Sec. 172(b)(2)absorption calculation, thereby increasing the NOL carryover to a succeeding year.

IRS ruled that, accordingly, the result in Rev Rul 76-145 and the result in Taxpayer’s case are not inconsistent; rather, the facts merely dictate a different result. If the facts of Taxpayer’s case were such that the 10% limit was greater than the current year charitable contributions, then Taxpayer would add the amount of the earliest year’s charitable carryover to the current year charitable contributions to the extent the charitable carryover also reduced modified taxable income in the absorption calculation of Code Sec. 172(b)(2) and increased the NOL carryover to a succeeding year under Code Sec. 172.

In Taxpayer’s case, IRS ruled, to the extent the charitable contributions in Year 2 reduced modified taxable income in the absorption calculation of Code Sec. 172(b)(2) and increased the NOL carryover to Year 3, the charitable carryover must be reduced by the amount of the Year 2 charitable contributions that increased the NOL carryover. Amount 8 of the Year 2 charitable contributions reduced modified taxable income and, thus, increased the NOL carryover so that the remainder should be carried over to Year 3.

Moreover, because the Year 1 charitable carryover expires in Year 2, it is not an excess contribution under Code Sec. 170(d)(2)(A). The charitable carryover from Year 1 may not be used because of the expiration of the five-year statute of limitations period.

Example explains rulings. IRS provided the following example explaining its rulings and analysis:

Suppose X Corp had $1,000 of taxable income in 2017 before considering its NOL carryovers or charitable contribution deduction. X Corp had NOL carryovers of $5,000 available to use in 2017, which included $100 from 2012 and $1,500 from 2013. X Corp also had charitable carryovers available to use in 2017 of $300, which included $150 from 2012. In 2017, X Corp made charitable contributions of $120.

In this example, like in Taxpayer’s case, X Corp cannot deduct any charitable contributions in 2017 because the NOL carryovers reduce taxable income for 2017 to zero. But, like Taxpayer, X Corp still must compute the 10% limit for purposes of determining modified taxable income and the amount of the NOL carryovers that are absorbed.

First, X Corp must subtract its 2012 NOL from its 2017 taxable income to determine the Code Sec. 170 taxable income ($1,000-$100=$900). X Corp must then multiply its Code Sec. 170 taxable income by the 10% limitation ($900x.10=$90). The $90 represents the amount of the 2017 charitable contribution that is allowed for purposes of calculating modified taxable income under Code Sec. 172(b)(2).

Second, because X Corp cannot deduct any charitable contributions in 2017 and it has NOL and charitable carryovers, it must determine how much of the 2017 charitable contributions it can carry over to 2018 after applying the Code Sec. 170(d)(2)(B) adjustment. X Corp must reduce its 2017 charitable contributions by $90 because that amount was allowed in the modified taxable income calculation ($900-$90=$810), resulting in an increased NOL carryover to 2018 and the charitable contributions not actually being deducted. The result is that only $30 ($120-$90) of the 2017 charitable contributions is allowed to be carried over to 2018.

Lastly, X Corp must calculate the amount of the 2013 NOL carryover that is absorbed under Code Sec. 172(b)(2) and the amount carried over to 2018. The 2013 NOL carryover is reduced by the amount absorbed, which is the 2017 modified taxable income, and the remainder is carried over to 2018 ($1,500-$810=$690).

In this example, like in Taxpayer’s case, only the current year charitable contributions are taken into account in calculating the Code Sec. 170(d)(2)(B) adjustment because the current year charitable contributions alone reduced modified taxable income in the absorption calculation of Code Sec. 172(b)(2) and increased the NOL carryover to a succeeding year under Code Sec. 172. Accordingly, X Corp loses the ability to use any charitable carryovers from 2012 as a result of the expiration of the five-year statute of limitations period.