- Business owners can deduct contributions to charities as an advertising expense if the expense is for a sponsorship.
- Income property owners also have a limited opportunity to deduct charitable contribution as an advertising expense for sponsorships as well.
- There are some caveats to deducting sponsorship expenses. The itemized deduction could be more valuable in certain instances due to the partial loss of the Qualified Business Deduction (QBI).
- There are some hidden benefits, too. Planning sponsorships can maximize certain tax credits and deductions for small business owners.
The Tax Cuts and Jobs Act (TCJA) of 2017 changed many of the rules. Personal exemptions were eliminated while the standard deduction was increased. With the state and local taxes deductions limited to $10,000 in aggregate, mortgage interest and charitable contributions carry virtually all the weight when it comes to itemizing deductions now.
Fewer taxpayers can itemize after the TCJA, hence, fewer get a tax benefit for supporting charities. This makes it more difficult for charities to raise funds to carry out their mission.
As with so many tax issues, there is a work-around for some taxpayers. Business owners and even income property owners can utilize a strategy that has worked for a very long time deducting monies paid to charities and other groups.
Whereas individuals face issues when deducting charitable contributions, business entities also have rules to follow that limit charitable donations. A sole proprietorship treats charitable contributions as having been given by the owner of the business and is reported on Schedule A. Partnerships and S corporations claim charitable contributions, but pass the deduction to owners on Schedule K-1 where the deduction is again claimed on Schedule A and the deduction is limited by the new realities of itemizing.
Regular corporations (sometimes referred to as C corporations) face even greater limitations. These entities can only deduct up to 10% of taxable income for any given year, with the excess carried to the next year.
Considering all these limitations when supporting a charitable organization, it requires planning to maximize the tax benefits so you can maximize the benefit to the charity. Individuals can clump charitable deductions in one year so itemizing comes into play those years. Regular corporations may find the restrictions too limiting to support an organization at the level desired under any circumstances.
Deductible Sponsorships as Charitable Giving
It is tempting to throw up your hands in defeat with all the new limitations on supporting your church or favorite charity. But not so fast!
Sponsorships are technically not charitable giving; they are an advertising or promotional expense to the business. It requires only a modest amount of planning to gain full deductibility of monies paid to non-profit organizations and other social groups.
It is easiest to think of this small at first. My tax office gets requests each year from local high school and junior high sports teams to buy a sponsorship. In exchange for a $250 fee, for example, they will add my business logo to the flyer handed out to all attendees. Sometimes they add the logo to signage at the sporting event. These small organizations may not even qualify as non-profit organizations so anything other than a sponsorship is not deductible by anyone. But as a sponsorship my business can deduct the full payment as an advertising expense.
A bit larger example is the $1,000 my office pays to CommunityFest some years in exchange for my business name and logo presented at the local community event over the Independence Day holiday.
These types of sponsorships don’t always bring in enough new business to cover the advertising cost. It does build goodwill for your business so it still counts as a business expense. Public exposure of your business offers the opportunity for new business so it is a deductible expense.
On these small scales an income property owner could also support charities in a similar fashion. If you have a brand name for your properties you can increase exposure and attract better tenants with strategically placed sponsorships. For businesses and income property owners the expense has to be reasonable. That is a wide road, but does have its limits. An income property owner with one small property probably cannot deduction a $200,000 sponsorship expense.
The numbers can be large, however. Recently I worked with an actor in a highly rated television program. He wanted to donate $1 million to his church that needed funding for an addition. He eventually settled on a sponsorship of $300,000 because a million dollars is a lot of money even for a successful actor.
Our actor friend was looking for a career shift and the sponsorship held possibilities. Even such a large sponsorship expense was acceptable due to the size of his income and the possibilities for more acting jobs in the future. I noticed he was picked up for a movie in a very popular series. I would say the expense qualified considering the results (though the expense is not required to generate large results which would be impossible to predict).
I use sponsorships to control my level of profits in my business, too. Keeping my income lower has its advantages, especially when there is a desire to support non-profit organizations. A surprise benefit is that I qualified for the recent stimulus checks due to my heavy level of sponsorship spending in past years.
Note: A sponsorship cannot support any particular individual, like a Special Olympics athlete. Fees to attend the event are also not allowed as a business expense. A logo on team uniforms would count as a business expense, however.
Sponsorship vs Deduction
Throwing money into the plate on Sunday morning is a charitable contribution no matter what way you cut it. I have business owners who try to add weekly tithes to their expense sheet. A quick inquiry eliminates the business expense and puts it back on Schedule A where is has less, if any, value.
However, there is nothing that says you have to drop money into the plate when it is passed. You can use sponsorships at the same level as your regular contributions. When your church has an event your business can sponsor the event for a business deduction. The biggest issue for some is not giving money during the church service. I suggest you give a token amount at the service or even drop an empty envelope in the plate. You are still meeting your charitable goals because of your support through sponsorships.
The non-profit also needs to follow some rules. As a sponsor you would qualify for an advertising deduction regardless the non-profit’s behavior. But you need to be aware certain behavior subjects the non-profit to UBIT (Unrelated Business Income Tax).
- The non-profit should never promise a certain attendance level to the event, media ratings or any other promise of the level of exposure that will be provided. The business still gets the deduction for the sponsorship, but the non-profit is subject to UBIT is such instances where the promise is made.
- A sponsorship should not require the business to allow the non-profit the use of business’s logo or products for unrelated event promotions. If the business allows the activity without the requirement it probably is okay. But if the sponsorship has the requirement the non-profit could be subject to UBIT.
- Conventions, trade shows, annual meetings and similar events can be sponsored by a business with the expense a deduction. The non-profit in these situations might be (probably is) subjected to UBIT.
I mention the three issues above so business owners do not demand the inclusion as part of the sponsorship. The biggest issue for the business owner is the promise of a certain attendance or ratings level. If the non-profit includes any of these items the non-profit may have tax issues to consider; the business owner still gets the deduction regardless, but the non-profit could suffer tax consequences.
Problems, Benefits and Solutions
The biggest concern with deducting sponsorships as a business expense is that it reduces your QBI, as mentioned in the opening bullet points. I can’t think of an instance where this would result in a worse outcome, but I throw it out there because it could be an issue for a minority of readers. QBI is generally 20% of profits. Therefore, a $10,000 business expense would only be worth an additional $8,000 because the non-cash QBI deduction is $2,000 without the deduction.
There are significant tax benefits from deducting sponsorship expenses. If your income is too high for the QBI deduction, a properly planned sponsorship could reduce your income so you do qualify. That would never happen deducting the expense as a charitable contribution as an itemized deduction.
I actively seek sponsorship opportunities to support organizations I like. Rather than a charitable contribution I invest (notice my choice of words) the same monies as a sponsorship. The organization gets the full benefit, my business gets a deduction and I pay less in tax.
The “lower tax benefit” is larger than first perceived. By lowering your income before it ends up on Form 1040 you also potentially increase the number of tax credits you qualify for. For lower income taxpayers the Earned Income Credit and Saver’s Credit become possible and may increase the credit. For taxpayers with higher income it can lower taxes on qualified dividends and long-term capital gains, and reduce or eliminate the Net Investment Income Tax (NIIT).
In all but the rarest of situations it is better to have a business expense than an itemized deduction. Turning charitable contributions into legal business expenses is the Holy Grail. With proper planning you can control your tax burden, maximizing the tax benefits each year. I was able to qualify for the stimulus check because my income was low enough thanks to the business deductions received from sponsorship deductions. If you didn’t qualify for a stimulus check due to income level, you may wish to review the options outlined above because you have one last chance to qualify on your 2020 tax return.
Finally, as my actor client illustrates, a desire to fund a non-profit organization can lead to very profitable outcomes. Of course then you have to deal with all that extra money. I’ll keep publishing blog posts with tax ideas your accountant forgot to mention to help out. You hold up your end of the bargain by funneling monies to awesome organizations and I’ll keep showing you how to pay less tax when the wheelbarrow of cash rolls in.
And it is all for a good cause.
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Today I have a very special guest I would like you to meet: George M. Cohan. George has been a regular fixture of my practice from nearly the first day. But he has one serious problem; he hates keeping business records.
There is a very good reason why Cohan doesn’t keep good records of his business expenses. He is a very famous Broadway actor. He also likes to enjoy his fame.
Well, the IRS came knocking and since most of his receipts were missing the expenses were disallowed. Cohan might be lax when it comes to keeping business records, but he can fight like a pit bull in the hot sun after a pair of double espressos. Our good friend was headed to court.
The IRS felt they had it in the bag. Unfortunately, the IRS had an education coming. The 2nd Circuit US Court of Appeals settled the case in our good friend’s favor. The court said when receipts are absent it would be impossible to get a perfectly accurate number. However, the court continued, allowing nothing is inconsistent when it is obvious there were expenses.
This court ruling happened March 3, 1930 and my office has never been the same.
Close Enough for Government Work
Paid tax preparers sign tax returns under threat of perjury that the return they are signing is true and accurate to the best of their knowledge. Too many tax professionals forget this as they quickly scribble their signature for the eighteen thousandth time this tax season.
The shoot from the hip response from most tax professionals is if you don’t have the receipt you don’t get the deduction. Sometimes, as we shall shortly see, this is true. Many times it is not.
Even when a client has records it may be necessary to make adjustments to reflect the facts and circumstances. A handful of returns grace my desk every year I wish never showed up in the office because I need to apply more art than science to the return. There is no other option.
Before we talk about adjusting deductions we need to set a few ground rules. The Cohan Rule doesn’t apply to every area of the tax return. The court ruled an approximation of business expenses, based on credible evidence other than actual documentation, was enough to sustain a deduction.
The Cohan Rule can be applied to most deductions or business expenses with the exception of travel, meals, entertainment and listed property (Section 274). Airfare and hotels need a receipt or the deduction is lost. Mileage records need to be contiguous. This means you need to record the information in your logbook near the time of the event and certainly before the tax return is filed. Meals under $75 don’t need a receipt, but you need to record the expense in your logbooks along with the business purpose of the meal and who you were talking with. Receipts for entertainment are required to qualify for the deduction.
What about that listed property thingy? Listed property consists of computers (and related peripherals) not used exclusively at a regular business establishment or qualified home office; vehicles susceptible to personal use; and property used for entertainment, recreation or amusement (i.e. video recorder). Cell phones are not considered listed property. No deduction/depreciation is allowed on listed property unless you can substantiate the expense (have a receipt). [IRC Sec. 274(d)(4)]
The Tax Court has provided plenty of help over the years in determining which instances we can use the Cohan Rule. There are also areas of inconsistency. A few years back the IRS started requiring charitable deduction receipts must be in your hand prior to filing the return. However, the Court has applied the Cohan Rule in some cases involving small charitable donations while disallowing the deduction if the amount donated involved $250 or more in any one donation.
To make it even more interesting, the Tax Court used the Cohan Rule when determining gambling losses in a 1991 case. Who would have thought?
Time to Get Creative
Now that the basics are out we can apply the Cohan Rule for more obvious cases to more creative uses of the rule.
A fire or theft could cost you your substantiation of deductions and the Cohan Rule would apply. A computer systems failure is a modern version of “the house burnt down” excuse.
Recreating deductions might not always be as hard as first thought. Bank statements are not technically receipts or allowable substantiation, but the IRS uses them all the time. Check stubs and statements from a vendor after the fact can get you reasonably accurate numbers the IRS should accept.
Certain tax forms like a 1099 can also do the trick as the IRS will already have that information. You can request a transcript from the IRS to see what they have on file as a good starting point to reconstruct a substantial or complete loss of documentation.
Now things get harder. You think you have all your receipts but they don’t make sense. I’ll use an example from a real client. Names and certain facts are changed to protect the guilt.
The client in question has a retail store. He expanded to a second store this last year. His paperwork was a mess. Some records were there, a lot was missing. When I added what appeared to be income it amounted to a massive increase over the prior year even adjusting for the new location.
After a dozen or so rounds with the client we were able to get a reasonably clean revenue number for the business. Reminder, the number I used was reasonably accurate. There was no way to guarantee it was absolutely accurate. As I sign the return, it was “true and accurate to the best of my knowledge”.
Now came the hard part. Major expenses were missing. Anything unsubstantiated under Section 274 was automatically lost per the Code. What we had, we used. No more, no less.
The other expenses were also obviously off and to make matters worse the client paid for many items, including inventory, with cash. (Please god, be kind to an accountant. Don’t use cash for business expenses with the exception of a few minor items from petty cash.)
Some receipts were illegible and the bookkeeping was incomplete and a mess. We had to reconstruct. I’ll save you the boring details and give you the important information. I used a model based on prior year data and expected ratios for the business at hand to determine reasonable numbers. It sounds easy, but it took a lot of time as I kept working the numbers until it all looked acceptable. In this case we had at least a few numbers to establish a baseline.
Whenever I rely on the Cohan Rule on a tax return I attach a statement clearly outlining what we did and how we arrived at the numbers we did. Whenever I have attached such a statement to a return the IRS has never, I said never, audited any of those returns. Maybe I am lucky or maybe the IRS figures if I went to that much trouble to get it right they would come to a similar conclusion.
The same applies in an audit. I take a lot of IRS audits from off the street. These people usually have a mess on their hands and missing receipts. When I bring up the Cohan Rule auditors have always been receptive once I outline how I will determine a reasonable number. I think they like my methodology because I am intense instead of guessing. I really devise a method to arrive at relatively clean numbers in pretty much any case. Auditors are usually impressed and if they aren’t their supervisor is. A few cases went to appeals over the years, but none to Tax Court and we always had end results within a nickel’s throw of where I said we would land.
Having your books and substantiation of deductions in order is the best policy. If disaster strikes you can rest assured there are alternatives for fixing most of the problem. Any additional tax liability should be small unless major Section 274 issues are involved.
Even bad bookkeeping has a solution. If a client brings in books that defy logic I must, as a tax professional, dig deeper. Sometimes the client has more material to clear up the issues. Sometimes I have to make adjustments. I disclose any adjustments to the IRS as an attachment to the return.
I sign my name attesting to the accuracy of a return to the IRS. I take that attestation seriously. When you sign your tax return you are making the same attestation I am. You can’t just file a return because that is what your books read or what a tax document or statement says. Statements can be wrong; books can be wrong.
Adjust obvious errors where allowed to reflect a more accurate return. Keep a record of the changes and the method used to reach the final numbers. I recommend attaching a statement to the return as well.
From now on you can sleep better knowing a lost receipt isn’t the end of the world. Make a note of it and take the deduction. The IRS (and the Tax Court) have your back on this one.