Editor: Frank J. O’Connell Jr., CPA, Esq.
Expenses & Deductions
Due to the most recent economic downturn, many corporate taxpayers accumulated significant carryovers of net operating losses (NOLs), alternative minimum tax (AMT) net operating losses (ATNOLs), and charitable deductions. As these corporations recover and generate taxable income, the use of these carryover items is becoming more prevalent, and one of the issues arising is the interplay of the 10% limit on charitable deductions and the 90% limit on ATNOLs.
General Overview of the Law
The issue involves primarily three Code sections and their corresponding regulations: Sec. 170 (charitable contributions), Sec. 172 (NOL deduction), and Secs. 55 and 56 (AMT).
Sec. 170(b)(2)(A) generally limits the amount of a corporation’s charitable deduction to no more than 10% of the corporation’s taxable income. Furthermore, Sec. 170(b)(2)(C) states that taxable income for this purpose is computed without regard to the charitable deduction itself, NOL carrybacks, capital loss carrybacks, and the Sec. 199 deduction. Sec. 170(d)(2) provides for a carryover period of five tax years for charitable deductions a corporation makes in a tax year that exceed the 10% limit. In determining which charitable contributions are deductible in a given tax year, current-year contributions take priority over carryover contributions. The 10% limit on charitable deductions also applies in computing a corporation’s alternative minimum taxable income (AMTI).
Secs. 172(c) and (d) define an NOL as the excess of allowable deductions over gross income, with specified modifications. Pursuant to Sec. 172(b)(2) and the regulations thereunder, the amount of the NOL that is absorbed in a carryover year equals the taxable income for that year determined with certain modifications (modified taxable income). Modified taxable income is determined without taking into account the NOL, and deductions that are limited to a percentage of taxable income are recomputed without regard to the NOL.
Sec. 56(d)(2)(A) generally requires a taxpayer to compute its ATNOL in the same manner as its NOL, with appropriate modifications for AMT adjustments and preference items. Sec. 56(d)(1)(A) limits the amount of ATNOL that may be deducted to the lesser of the ATNOL or 90% of AMTI computed without regard to the ATNOL deduction or the Sec. 199 deduction.
Ambiguous Ordering Rules
Based on the Code provisions cited above, a corporation’s 90% limit on its ATNOL deduction must be based on income that includes the charitable deduction, while the corporation’s 10% limit on its charitable deduction must be based on income that includes the ATNOL deduction. However, there is no statutory ordering rule that specifies which deduction takes priority, leaving uncertain how they both should be applied.
In June 2012, the IRS Office of Chief Counsel issued Chief Counsel Advice (CCA) 201226021, which gives some insight on the issue. According to the CCA, simultaneous linear equations have been used in analogous situations and may be appropriate in this situation. However, due to the lack of clear guidance in the Code or regulations, taxpayers may use any reasonable approach to determine the proper amount of each deduction. One such approach, which is also used by a major tax preparation software vendor, is examined below.
Interplay of Charitable and ATNOL Deductions
The following facts apply to the examples below with respect to Corporation X:
- Current-year charitable contributions = $50,000
- Charitable contribution carryover (for regular tax and AMT purposes) = $450,000
- NOL carryover = $7 million
- ATNOL carryover = $5 million
- AMT preference items = $50,000
- Taxable income before charitable deduction and NOL carryover = $1 million
Example 1: Corporation X has taxable income of $1 million before the charitable deduction, with no NOL or ATNOL carryovers. As illustrated in Exhibit 1, the charitable deduction limits for regular tax and AMT purposes differ slightly, based on the corresponding computation of taxable income. For regular tax purposes, the $50,000 of current-year charitable contributions is first applied, with $50,000 of the prior-year carryover then applied. For AMT purposes, the additional $5,000 charitable deduction is applied against the charitable contribution carryover.
Example 2: Assume the same facts as Example 1, except that Corporation X has an NOL carryover of $7 million and no ATNOL carryover. As illustrated in Exhibit 2, there is no regular tax charitable deduction because the NOL carryover fully offsets taxable income. Based on the calculation of modified taxable income, the charitable deduction that would have been otherwise allowed as a deduction absent the NOL carryover will “convert” to an NOL, with a corresponding reduction in the charitable contribution carryover. Therefore, the $100,000 charitable deduction in Exhibit 2 converts to an NOL carryover.
Example 3: Assume the same facts as Example 2, except that Corporation X also has an ATNOL carryover of $5 million. As illustrated in Exhibit 3, one approach to the interplay between the 10% limit on the charitable deduction and the 90% limit on the ATNOL deduction is to apply the 10% charitable contribution limit first. The 10% limit on the charitable deduction for AMT purposes would first be calculated on taxable income without regard to the charitable deduction and the NOL carryover (Step 1). This result would then be factored into the computation of the 90% limit on the ATNOL deduction (Step 2). Per Sec. 172(b)(2) and the regulations thereunder, the NOL to be absorbed would be calculated based on modified taxable income as defined above. Similarly, the ATNOL would be computed under the same rules. Consequently, the ATNOL would be the modified AMTI computed before the 90% limit on the ATNOL. The 10% limit on the charitable deduction is thus calculated on the difference between this amount and the AMTI before the charitable deduction and the ATNOL (Step 3). Finally, the recomputed 10% limit on the charitable deduction is factored into the computation of AMTI, less the ATNOL as computed above (Step 4).
In this example, since the 10% limit on the charitable deduction takes precedence, the ATNOL deducted on Form 4626, Alternative Minimum Tax—Corporations, is 90% of AMTI computed with the 10% limit on the charitable deduction as calculated in Step 1. With this approach, the ultimate ATNOL deduction is less than the 90% limit generally allowed. This result is also affirmed by the simultaneous linear equations as shown in CCA 201226021.
Note: Depending on what ordering rules are followed, as well as the particular fact patterns, tax practitioners will get varying results.
Ensuring Proper Interplay of the Rules
The uncertainty surrounding the ordering rules of the 10% limit on the charitable deduction and the 90% limit on the ATNOL deduction has been affecting more corporate taxpayers as the economy recovers and these corporations start generating current-period taxable income. Corporations affected by these rules should know how their tax preparation software is computing the deductions to ensure that it is appropriately accounting for the interplay between the rules. It should also be noted that this item does not address any implications of when an NOL carryover is being limited by Sec. 382. Corporations should consult their tax advisers if this situation applies to them.
Frank J. O’Connell Jr. is a partner with Crowe Horwath LLP in Oak Brook, Ill.
For additional information about these items, contact Mr. O’Connell at 630-574-1619 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.