This lesson explains the fundamental tax principle associated with charitable gifts and how the bookkeeper records the entry as a part of their daily operations. There are some documentation requirements that must be followed for proper accounting purposes. Throughout this lesson I’ll identify some common donation venues and how the bookkeeper should properly record the gift. This includes using staff and company property to carry out the charitable function.
Tax Principles With Charitable Giving
The Internal Revenue Service allows legally recognized entities such as individuals, corporations (C-Corporations) and non-profits to donate money to charity. Other forms of legal entities are merely paper entities comprised of an individual or several individuals. These types of entities are commonly referred to as pass-through entities. This means any tax attributes such as income, gains and charitable deductions are assigned to the owners via Form K-1. The owners then pick up this income, gains and deductions (charitable gifts) on their personal Form 1040 as if they had this on their own.
Pass-Through entities include:
- Sole Proprietorship – use a Schedule C, Form 1040 to report information
- Limited Liability Company (LLC’s)
Individuals deduct charitable giving on Schedule A – Itemized Deductions with certain limits. Basically, C-Corporations are the only business form (there are others, but that goes beyond the scope of this lesson) that is allowed to deduct charitable gifts. This is because C-Corporations pay income taxes on profit whereas pass-through entities do not, they pass the tax attribute onto their owners via Form K-1.
Almost all small businesses exist in some form other than as a C-Corporation. To give you an idea of how this works let’s compare a C-Corporation taxable income to a pass-through entity’s net result and on down to the individual owners.
. C-Corporation Pass-Through Entity
Net Income B/F Gift $100,000 $100,000
Gift Deduction (10,000) -0-
Net Taxable Income 90,000 100,000
Income Assigned to Owners -0- 100,000
Charitable Deduction (Owners) -0- (10,000)
Taxable Income $90,000 $90,000
. Corporation Pays Individuals Pay
. the Income Tax the Income Tax
The charitable gift is still a function of book income and is added back for tax purposes with pass-through entities. It is referred to as a tax difference item in professional accounting (preparation of tax papers).
One of the interesting aspects of charitable giving is the tax savings it generates for a business or individual. At the individual level the tax savings is always at the individual’s tax rate. So if an individual’s tax rate is 10% (adjusted taxable income less than $50,000 per year) the tax savings is a mere 1/10th of the donation. Whereas for high taxable income levels where the tax rate is 34%, the gift often makes a significant impact on the taxpayer’s tax obligation.
Because of this tax variance I often remind small business owners that it is more important to focus on earning a profit than to donate to charity. The net tax benefit is insignificant. Furthermore, charitable gifts affect cash flow with business operations. However, this doesn’t mean I’m against charitable giving; it means that owners should give from their hearts and not because they believe that they are saving significant dollars in taxes. I can’t tell you how many small business owners believe it is similar to a direct tax credit, i.e. a dollar for dollar value.
Given all this, owners still donate regularly and it is the accountant’s job to record these entries to the books of record.
Bookkeeping of Charitable Gifts
Many owners of small business serve as directors and fund-raisers for their charity of choice. It often is due to some historical connection to that cause. As a part of this the owner donates to this charity on a regular basis. This gift is recorded to the books as an expense. In general, the expenses section of the income statement is divided into seven major groups as follows:
- Management – Officers, management, office staff payroll and benefits
- Facilities – Rent, maintenance, utilities and CAM fees
- Insurance – Various types including general liability, professional, property, worker’s compensation) and umbrella
- Office – Technology, communication, supplies, warranties etc.
- Taxes & Licenses – Revenue taxes, property, business licenses and state compliance licenses
- Other – Professional fees, advertising, banking and miscellaneous
- Capital – Depreciation, amortization, interest on debt
The ‘Other’ group is where charitable giving is located when designing the chart of accounts. A typical layout for other is as follows:
. – Professional Fees (legal, accounting and consulting)
. – Marketing and Advertising
. – Banking
. – Travel/Training (sometimes located in the Office section of expenses)
. – Charitable Gifts
. – Meals and Entertainment
. – Miscellaneous
The entry is recorded in either the purchases journal or the general journal. Once the item is recorded, go into the working trial balance and add a spreadsheet for charitable gifts. Include this information for this donation on this sheet. Take note, this is a book to tax difference used by CPA’s to reconcile the book income to taxable income in a similar manner as depreciation differences are calculated.
There are many ways owners donate to a charity, some require bookkeeping, others don’t. Here is a list and short description of how it is booked for accounting purposes.
A) Use of Facilities or Equipment – We’ve all seen this where a dealership or a company runs a fundraiser from their location. Whether it’s an hour or an entire day, there is no real tax deduction here. Why? Because the rent or equipment costs associated with that day are paid via normal operations in the books of record. This even includes the consumption of supplies to run the event. Technically the accountant could break down the costs to the amount for normal operations and the amount truly donated to the charity; such as 1/30th of the rent is charity and 29/30ths is for business. But the costs to do this would be greater than the value donated. In effect, this type of donation is inconsequential to the final tax implication and should simply be ignored.
B) Use of Paid Staff – Often owners have the staff perform services or augment events as a part of their wages. This is very similar to the use of facilities. The bookkeeper can break out the part of the payroll attributable to this service and record it as a donation. The end result is shifting of an expense deduction to a tax difference item. In most cases the value shifted is of de minimis value. So it isn’t worth the heartache and time to do the accounting. The deduction exists in payroll as a normal cost of labor.
C) Donation of Fixed Assets – Sometimes owners donate old office equipment or outdated equipment (TV’s, network systems, software). Most likely this equipment is fully depreciated for tax purposes. Therefore the net book value is zero. So no financial gift is made in the eyes of the IRS. However, for book and tax purposes the asset must be accounted for as ‘Disposed’. Basically to remove the asset from the books, the entry is a credit to the fixed asset account for its original purchase price and a debit to accumulated depreciation (normally a credit balance).
D) Purchase of Advertising in a Program – Have you ever been to a high school football game and bought the program? Inside are dozens of local businesses touting the team and school. Well these advertisements come at a price for the business. Often owners write them off as a donation as the advertisement rarely if ever brings a fan in the front door. This cost is marketing and advertising and not charity; poor marketing and advertising but still advertising. Some parts of being a local business means being a good citizen and helping out the local high school by purchasing an ad spot.
Documentation of Charitable Gifts
In a typical transaction a bill or contract provides the underlying source document to record the entry. With charity, this is actually rare. Better organizations send a receipt or a letter of thanks recognizing the donation amount.
The initial entry is typically a demand from the owner to cut a check to so and so for a certain amount. The check itself acts as a receipt. Once cashed, pull a PDF of the front and back; and add the document as an attachment to the entry itself. Make it a link in the spreadsheet. Any mailed receipt is also scanned into the donation account and the original hard copy goes to a folder for charity for that respective year in case of an audit by the IRS.
As a sidenote to this, the IRS often conducts ‘Single Line Item Audits’ and charitable giving is one of the more common. The taxpayer gets a letter asking for proof of the taxpayer’s donations. So copies of letters, receipts and paid checks provide this evidence.
A few insights to charitable donations are appropriate at this point. Earlier I explained the tax attributes of charitable gifts. Since most small businesses are pass-through entities, the income assigned is often as ‘Earned Income’ and therefore taxed for both income taxes and self-employment taxes. Although the gift is deductible for income taxes, it is not deductible for self-employment taxes. This makes the C-Corporation and S-Corporation slightly more advantageous over limited liability corporations and partnerships. Another common protocol in the charity industry is for directors (often owners of a small business) to pledge a dollar amount over the next year. So the question is: ‘Is this a current liability to the business?’; after all, the owner committed the business to donate the money. The answer is no. This is because there is no enforceable contract; pledges are not contracts and therefore they are unenforceable statements or agreements.
This is true even if there is a signature on a pledge agreement. One last item, owners often get carried away with their willingness to donate money. Owners and management should set a maximum yearly amount to donate. Anything in excess takes away from the three primary goals of business:
1) Make a profit
2) Provide long-term employment security
3) Deliver quality product and service to the customer by fulfilling a need
Summary – Charitable Giving
The tax code greatly affects charitable giving in small business. Since most small businesses are configured as pass-through entities for tax purposes, the charitable component is a book to tax difference. In effect, the individual owners take the deduction on their personal Schedule A of Form 1040. Even so, the business is paying the dollar amount and therefore the donation requires accurate accounting and documentation.
A separate account is set up under the ‘Other’ group in the expenses section of the income statement for the purpose of recording the donations. Actual financial gifts are entered here via the purchases or general journal and receipts must be kept for documentation purposes. Non cash gifts of time, facilities and payroll are generally not recorded to charitable giving but are left as expenses where customarily posted. Be sure to post pseudo gifts like program ads to a more appropriate account and not as charity. ACT ON KNOWLEDGE.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.