For pharmaceutical companies that aim to improve cash flow while serving the public good, Internal Revenue Code (IRC) 170(e)(3) provides an enhanced charitable deduction. Typically, donated inventory falls under the scope of IRC 170(e)(1)(a) and is met with three limitations:
- The charitable deduction of inventory is limited to the tax basis in the inventory.
- Assuming a difference in the tax basis and fair market value (FMV) of the inventory, the charitable deduction must be reduced by the amount of ordinary income that would be realized if the inventory had been sold at arm’s length.
- The ultimate charitable deduction can only be taken to the extent of 10% of the current year’s corporate taxable income; if there is insufficient taxable income in the current year to take the entire charitable deduction, the excess is carried forward for five years.
IRC 170(e)(3) aims to enhance upon the 2nd limitation noted above by providing a corporation the opportunity to take a deduction equal to the lesser of:
- The basis of the contributed property plus one-half of the ordinary income that would be realized if the property were sold for FMV, or
- Twice the tax basis of the contributed property.
Let’s illustrate the enhanced deduction available under IRC 170(e)(3):
- Inventory X costs $100 to produce (tax basis).
- FMV is $150.
- If inventory X was sold at arm’s length,$50 of ordinary income would be generated.
Under the first test the tax basis + 50% of the ordinary income generates a deduction of $125 ($100 + $50*.50). However, the analysis must move on to the second test.
The second test dictates that the charitable deduction is two times the tax basis, so $200 ($100 x 2).
Because the enhanced deduction is limited to the lesser of the two tests, the deduction is $125.
If a taxpayer wishes to pursue the enhanced deduction, there are basic conditions that must be met:
- The donated product/inventory is used solely for the care of the ill, needy, or infants.
- The taxpayer must obtain a written statement by the Donee organization stating that the donation is to be used for qualified purposes.
- The Donee organization must be a US 501(c)(3) charitable organization.
- The donation must be made by a C corporation.
WG observation: Taking advantage of IRC 170(e)(3) is elective and not required by pharmaceutical companies. Because charitable deductions are limited to 10% of a corporation’s taxable income and can only carry forward 5 years before they are lost to the taxpayer it is important to weigh the pros and cons of donating versus disposing of the inventory versus selling the inventory at a loss.