Taxpayers who give to charitable organizations may be rewarded by a reduction in the amount of federal and state income taxes they pay. Some charitable taxpayers give money, while others donate items. Unreimbursed expenditures on behalf of a charitable organization, however, are not really money, nor are they really items; they are somewhere in between. When taxpayers take deductions for expenditures in this gray area, the IRS often takes exception, resulting in a disallowed deduction and higher taxes due. In some cases, taxpayers have contested the IRS’s denial in the courts in an effort to retain their charitable deductions. This article will examine unreimbursed charitable expenditures, by definition and by court cases, so that taxpayers and their advisors can develop strategies to maintain deductibility. It also addresses recent changes in the tax law that may also affect the deductibility of unreimbursed charitable expenditures and other charitable donations.
Unreimbursed Charitable Expenditures Defined
Internal Revenue Code (IRC) section 170(a)(1) states as a general rule, “There shall be allowed as a deduction any charitable contribution payment of which is made within the taxable year,” provided those contributions are for the use of organizations defined in IRC section 170(c) and do not exceed specified limitations (presented below). An unreimbursed charitable expenditure is money spent on behalf of a charitable organization without transferring the money or the resulting purchase to the organization. The following two examples demonstrate:
- Sue purchased dog food and fed it to a dog that she was fostering in her home for the Humane Society. If Sue gave money to the Humane Society, she would be entitled to a deduction for a cash donation. If Sue purchased dog food and gave that to the Humane Society, she would be entitled to a deduction for donation of items. But in this case neither the money nor the food was given to the Humane Society.
- Bill helps the Humane Society manage its mailing list. Bill purchased a computer to store and process the mailing list data. Neither the money nor the computer was given to the Humane Society.
Both Sue and Bill incurred expenses while performing volunteer services for a charitable organization, and neither received reimbursement. Are they entitled to a tax deduction for these unreimbursed charitable expenditures? In general, the answer is yes. According to Treasury Regulations section 170, unreimbursed expenditures made incident to the rendition of services to an organization may constitute a deductible contribution [Treasury Regulations section 1.170A-1(g)]. As with all deductible expenses, unreimbursed expenses must be substantiated.
A charitable deduction is not allowed for services performed by a volunteer on behalf of a charity, or for a volunteer’s time expended doing charitable work. Therefore, a volunteer’s charity work is a nondeductible contribution of personal services. A charitable deduction is available, however, for unreimbursed expenses, including any automobile expenses incurred while rendering services to a charitable organization. This seemingly simple issue becomes complicated when there is no clear distinction between a charitable expenditure and a personal expenditure. Referring back to the two previous examples, one can see where distinctions are not clear:
- Sue may have two dogs of her own that also eat the food. Now she is purchasing food for three dogs, but only one-third of that food is for the purpose of charity. It may be unreasonable to feed the foster dog out of one food supply and her dogs out of another.
- Bill may play video games on the computer in his spare time. While that does not diminish its use for maintaining the charity’s mailing list, the computer is now being used partially for personal purposes.
When the expenditure is not easily distinguished as charitable or personal, the IRS often takes exception and may deny the deductibility of the expenditure.
Deductibility of Unreimbursed Expenditures
To be deductible, courts have ruled that unreimbursed expenditures must be directly connected with and solely attributable to the performance of services to a charitable organization [e.g., Babilonia v. Comm’r, 681 F.2d 678 (9th Cir. 1982)]. When applying this standard, courts have considered whether the charitable work caused or necessitated the taxpayer’s expenses [e.g., Orr v. U.S., 343 F.2d 553 (5th Cir. 1965)]. In addition, charitable deductions, including unreimbursed expenditures, are subject to recordkeeping requirements and substantiation requirements, including specific rules if the gifts are $250 or more.
IRS Publication 1771, Charitable Contributions—Substantiation and Disclosure Requirements, documents these substantiation requirements for unreimbursed expenditures. The taxpayer is responsible for maintaining adequate records of the unreimbursed expenses claimed on a tax return; those records must indicate the amount of the expenditure and demonstrate that each expense was for volunteer or charitable purposes, not for personal purposes. If a taxpayer makes a single contribution of $250 or more in the form of unreimbursed expenses (e.g., out-of-pocket supplies or transportation expenses incurred to perform donated services to an organization), then the taxpayer must obtain written acknowledgment from the organization containing—
- a description of the services provided by the donor;
- a statement of whether the organization provided goods or services in return for the contribution;
- a description and good-faith estimate of the value of goods or services, if any, that the organization provided in return for the contribution; and
- a statement that goods or services, if any, that the organization provided in return for the contribution consisted entirely of intangible religious benefits, if that were the case.
A separate acknowledgment may be provided for each contribution of $250 or more, or one annual summary document may be used to substantiate several single contributions of $250 or more. A taxpayer must obtain the written acknowledgment from the qualifying organization on or before the earlier of 1) the date the taxpayer files the return for the year the contribution is made, or 2) the due date, including extensions, for filing the return. A charitable organization that does not acknowledge a contribution incurs no penalty; however, without a written acknowledgment, a donor cannot claim the tax deduction.
Courts Can Be Uncharitable
The tax code encourages charitable contributions via the ability to reduce one’s tax liability. The IRS also closely monitors this area, given that many taxpayers fail to keep appropriate records of charitable giving. There is no requirement that evidence of charitable contributions be submitted with the tax return, making this an area ripe for overstatement of contributions. The problem is particularly acute for noncash charitable contributions, including donated items and unreimbursed charitable expenses. Paul Bonner highlighted this issue when he reported that the Treasury Inspector General for Tax Administration found the error rate for 2010 tax returns to be approximately 60% for noncash charitable contributions (“TIGTA: Noncash Charitable Contribution Claims Still Often Erroneous,” Journal of Accountancy, May 2013, http://bit.ly/2GibOdb). Most of the problems stemmed from noncash charitable contributions valued in excess of $500.
The taxpayer is responsible for maintaining adequate records of the unreimbursed expenses claimed on a tax return.
Noncash donations are also extremely popular with taxpayers. For example, Gerald Auten reported that more than 50% of taxpayers, spanning all income brackets, claim noncash charitable contributions (“What Do Taxpayers Deduct? A First Look at New Evidence on Noncash Charitable Deductions,” Proceedings, Annual Conference on Taxation and Minutes of the Annual Meeting of the National Tax Association, 2005, http://bit.ly/2IuB9lH). Given the problems associated with taxpayer compliance with the rules governing noncash charitable contributions, it is easy to see that there is some confusion regarding how to handle unreimbursed charitable expenditures. Fortunately, there is some guidance to be found in recent tax cases.
Van Dusen v. Comm’r.
In 2004, Van Dusen claimed itemized deductions related to expenses incurred while fostering approximately 80 cats in her home. Van Dusen provided the foster care at the request of a recognized charitable organization that also provided direct oversight of her services. The unreimbursed charitable expenses deducted by Van Dusen totaled $12,068; these expenses included veterinary expenses, pet supplies, cleaning supplies, and utility expenses.
The Tax Court issued findings in 2011, with mixed results [Van Dusen v. Comm’r, 136 T.C. 515, 523–24 (2011)]. The court noted that the most important consideration in determining deductibility of unreimbursed expenses is whether the volunteer work causes the expense. If the expense is incurred solely in connection with one’s duties as a volunteer, then the expense is deductible. If, however, the expense would have been incurred regardless of one’s duties as a volunteer, then the expense will not be considered a charitable expenditure, and thus not a deductible expense. The court held that four factors will be considered in determining whether services are “to or on behalf of” a charitable organization for purposes of determining whether the expenses are deductible: 1) the strength of the taxpayer’s affiliation with the organization, 2) the organization’s ability to initiate or request volunteer services from the taxpayer, 3) the organization’s supervision of the taxpayer’s work, and 4) the taxpayer’s accountability to the organization.
Van Dusen was found to have incurred unreimbursed expenses for a recognized charity and did substantially comply with IRS recordkeeping requirements for cash donations of less than $250 [Treasury Regulations section 1.170A-13(a)]. These rules were determined to apply because donations of less than $250 are either cash or property; thus, her expenses “more closely resembled cash donations.”
Van Dusen was allowed to deduct 90% of her veterinary expenses and pet supplies; 10% was disallowed due to the fact that Van Dusen also had seven cats that were pets and not part of the 70 to 80 foster cats typically residing at her home. In addition, she was able to deduct 50% of her cleaning supplies and utility bills. In all cases, Van Dusen had expense receipts and was able to provide documentation of the cash outlay.
Some of Van Dusen’s expenses were disallowed, however, because the court determined they were not completely related to the care of the foster cats. Examples include the cost of cremating a pet cat, her bar association dues (Van Dusen is a lawyer), and DMV fees. Other expenses were disallowed because the money spent on pet supplies at various retailers could not be determined via examination of the receipts.
Bell v. Comm’r.
In another case, Bell was disallowed a noncash charitable contribution related to her 2006 tax return. In 2013, the courts denied Bell’s expenditures for building materials used to remodel a building allegedly owned by a charitable foundation created to teach adult literacy [Bell v. Comm’r, T.C. Summary Opinion 2013-20 (U.S.T.C. Mar. 4, 2013)]. The basis for denying Bell’s expenses stemmed from her failure to provide evidence that the charitable organization owned the assets that were remodeled. Bell claimed to have donated the assets to the charity she established but could not provide evidence of the transfer of title. Of note is that Bell was also a licensed CPA and accounting professor.
Bradley v. Comm’r.
In another case, Bradley was allowed to deduct noncash charitable contributions related to volunteering as a football league cheerleader coach [Bradley v. Comm’r, T.C. Summary Opinion 2011-120 (U.S.T.C. Oct. 12, 2011)]. Bradley claimed expenses for a cheerleader team party at her home and automobile mileage expenses associated with attending practices and games. She was, however, denied the ability to deduct the expense of chartering a bus for the cheerleaders because she did not have “any written acknowledgment from the donee organization with respect to her contribution.”
While the courts have allowed fractions of overall expenditures to be assigned to personal and charitable categories, it is much simpler to identify the exact amount via separate billing.
Suggestions to Keep Charitable Giving Deductible
As evidenced above, the courts have established some guidance on how to treat unreimbursed noncash charitable expenditures. The general advice to charitable taxpayers and their financial advisors is to keep good records that establish clear links between the unreimbursed noncash charitable contributions and the specific charity. Seven specific recommendations gleaned from these cases follow.
Keep charitable and personal expenditures separate.
Ideally, keep all volunteer-related expenditures completely separate from personal expenditures; this will help protect a taxpayer against any IRS claims that the expenditures were not deductible. While the courts have allowed fractions of overall expenditures to be assigned to personal and charitable categories, it is much simpler to identify the exact amount via separate billing; for example, Van Dusen could have purchased pet supplies for the foster cats separately from those purchased for her pets.
If intermingling cannot be avoided, find clear ways of delineating charity from personal.
For example, each time Sue purchases dog food, she can buy three bags and deduct one or deduct only one-third of each bag. In the case of Van Dusen’s utility bills, it likely would be appropriate to deduct the difference between average utility bills paid prior to the charitable action and utility bills incurred after the charitable action.
Ask the charity to purchase the items needed, and donate cash to cover the expense.
This will provide clear documentation of a donation of cash, which is less likely to be controversial than an out-of-pocket expenditure.
Ask the charity to acknowledge the expenditure as an in-kind donation.
An in-kind donation is a gift that can be used or sold and is measured at fair market value [Accounting Standards Codification (ASC) 958-605-30-11]. Once recognized, an in-kind donation is treated as any other asset. For example, if a $50 box of envelopes is donated to a charity for a mailout, the charity recognizes a $50 donation (income) and a $50 expenditure (expense), resulting in no net effect on its financial statements. Most charitable organizations are already set up to acknowledge donated items as in-kind. In addition to generating a “tax receipt” for the donor, recognition of in-kind donations adds legitimacy simply by having the charity agree that the expenditure was a necessary part of operations. Certainly having the beneficiary of the charity support a claim would be compelling; recall that a charter bus expense was disallowed in Bradleybecause no written acknowledgment from the charity existed. In addition, acknowledging and recording in-kind donations in its financial statements helps the charitable organization in determining and presenting the true cost of operations. If the in-kind donations were kept off book, all the goods and services used to operate the organization would not be reflected in the financial statements.
Provide a clear link between the expense and the charity.
Most of the disallowed expenses in Van Dusen related to the fact that the taxpayer could not substantiate that the expenses would not have been incurred otherwise. Examples include her DMV fees and various membership dues.
Ask the charity to provide a letter stating the expenses are periodically incurred.
If a taxpayer can demonstrate a strong affiliation with the charitable organization, it is more likely the Tax Court will concur that the unreimbursed expenses were incurred on behalf of the organization.
Pay with a personal check and include a note in the memo section.
While debit and credit cards are easy to use, they may not provide sufficient detail about the purchase. Listing the donor organization for which the expenses are being incurred on the memo line of a check provides additional details.
Tax Effects of Charitable Contributions
Americans are a charitable lot; according to the Giving USA Foundation, charitable giving from individuals, foundations, and corporations all increased in 2016 (“Total Charitable Donations Rise to New High of $390.05 Billions,” June 12, 2017, http://bit.ly/2Ig6NEw). Giving by individuals totaled an estimated $281.86 billion, rising 3.9% (2.6% adjusted for inflation). Both personal consumption and disposable personal income grew by nearly 4% over 2015, possibly contributing to this increase. According to the National Center for Charitable Statistics (NCCS), approximately 67% of all U.S. households donate to some charity throughout the course of the year (Charitable Giving in America: Some Facts and Figures, 2013). While it does not necessarily drive American generosity, the tax deductibility of charitable contributions does ease the burden if a taxpayer itemizes.
Prior to the Tax Cuts and Jobs Act of 2017 (TCJA), charitable contributions were tax deductible to individual taxpayers (including couples and families) who itemize and to corporations, both subject to some limitations on an amount in a given year. The TCJA did not make significant modification to the language related to the deductibility of charitable contributions. The Exhibit summarizes some of the limitations for individuals before and after the TCJA.
Comparison of Charitable Contribution Deduction Limits
On the surface, it seems that the deductibility of charitable contributions has improved with the new tax law; limitations increased from 50% to 60% of adjusted gross income, and Pease limitations on itemized deductions no longer exist. Other changes, however, may well reduce charitable giving. For individual taxpayers, the new law raises the standard deduction significantly, from $6,350 to $12,000 for single taxpayers, and from $12,700 to $24,000 for couples filing jointly. As a result, far more taxpayers will be taking the standard deduction and not itemizing, which precludes deduction of charitable contributions. The Joint Committee on Taxation of the U.S. Congress estimates that 87% of taxpayers will take the standard deduction for 2018 filings, putting charitable deductions out of their reach (Overview of the Federal Tax System as in Effect for 2018,http://bit.ly/2IrcsGO).
There are two broad perspectives on how the TCJA will affect charitable giving by individuals. A more negative view is that taxpayers who used to itemize will begin taking the larger standard deduction, thus receiving no tax benefits from charitable giving, and potentially giving less. The more positive view is that the higher standard deduction will greatly reduce the tax liability of individuals who did not itemize before. This reduction in the tax liability of individuals frees up more dollars for charitable giving. It remains to be seen which view will be borne out, but the Nation Council of Nonprofits cites estimates that taxpayers will give $13 billion less in charitable donations each year as a result of this tax law change (Tax Cuts and Jobs Act, A.R. 1: Nonprofit Analysis of the Final Tax Law, Apr. 5, 2018, http://bit.ly/2Gk96E7).
The good news is that taxpayers’ generosity can be partially rewarded by the tax code if they keep good records, follow the advice above, and itemize. Taxpayers who have lost their ability to itemize and thus deduct charitable contributions may find that they have lost part of what drove them to donate to charitable organizations. One possible strategy to continue to deduct charitable giving is called bunching (Mark Miller, “Charitable Giving after Tax Reform,” American Endowment Foundation, http://bit.ly/2UKzXS3). Bunching charitable donations is a strategy of saving the cash and items one might donate over two or more years and making all the donations in a single year; the total dollar amount would enable the taxpayer to itemize. This strategy might be effective for taxpayers to give enough in two or three years to clear the higher standard deduction. For those taxpayers who give relatively small amounts, however, it would take a long time to aggregate enough funds, during which the charitable organizations would be left waiting. Bunching also would not help with out-of-pocket expenses for ongoing services to charity, because those must be deducted in the year they are incurred. Donating cash to charities (bunched or otherwise) and allowing them to pay for those expenses directly is, however, still an option.