Charitable Deductions for Defective Inventory – Houston Tax Attorneys

Manufacturers and retailers frequently face the challenge of handling defective or obsolete inventory that cannot be sold. This situation often results in waste. The inventory has some utility or value, but the benefit of repurposing or rehabilitating the inventory is often outweighed by the cost of handling or repurposing the inventory.

Examples are easy to envision, such as a clothing manufacturer with items that are mis-sewn and unsuitable for sale under a major brand or grocery stores and restaurants with day-old food items that cannot be sold.

While simply writing off inventory or taking a tax loss is one option, there may be a more beneficial alternative—donating it to charity. The tax code provides specific provisions to encourage this practice, aiming to prevent waste and incentivize for-profit businesses to consider options beyond disposal. For certain C corporations, these provisions include an enhanced charitable deduction that can make donating inventory even more advantageous.

The recent IQ Holdings v. Commissioner, T.C. Memo. 2024-95, case provides an opportunity to consider this issue and, although not addressed in the case, the enhanced inventory deduction.

Facts & Procedural History

The taxpayer in this case is a C corporation. It manufactured aerosol consumer products through its subsidiary. The part of the case relevant to this article is the taxpayer’s inventory.

The taxpayer ended up with two sets of defective inventory: its own branded products that had become rusted and damaged, and WD-40 products that had a design defect making them non-compliant with Department of Transportation regulations. The total cost basis of this inventory was approximately $4.7 million.

The company formed a non-profit focused on healthcare products in 2012. While waiting for IRS approval of the organization’s tax-exempt status, the taxpayer made a seller-financed sale of the inventory to the non-profit. The plan was to forgive the loan once tax-exempt status was granted. However, by the time approval came in 2014, the inventory had further deteriorated and the taxpayer changed course by reversing the sale to the non-profit and deducting the inventory by reducing cost of goods sold.

The IRS conducted an audit and proposed several adjustments. One of the adjustments was to the cost of goods sold deduction for the inventory adjustment. The IRS dispute ended up in tax court and this court opinion was just an order on a motion for summary judgment. The inventory issue gets into how the rules apply when the inventory may have no value. The court will likely take that issue up further in this litigation, but for purposes of this article, we are just focused on the fact pattern of the C corporation with defective inventory and how that can benefit some taxpayers–which isn’t the issue that the court will eventually decide in this case.

The Accrual Method Requirement

Before getting into the charitable deduction rules, it’s important to understand that inventory donations for businesses primarily involve accrual method taxpayers.

The accrual method requires taxpayers to report income when earned and expenses when incurred, regardless of when payment is received or made. This method aims to match income and expenses in the proper tax year. For example, if a business performs services in December but isn’t paid until January, the income is reported in December under the accrual method. The same goes for expenses. If the taxpayer purchases inventory, they generally deduct the cost of the inventory when the item is sold.

Compare this to the cash method, where income is reported when received and expenses are deducted when paid. The cash method is generally simpler and preferred by most small businesses as it matches the actual cash flow.

Most taxpayers prefer to use the cash method and look for ways to qualify. There are several reasons for this, such as the need to maintain accounting records which often requires the business to hire a proper accountant. The other major consideration is inventory which has several nuanced requirements, as noted above. Accrual method taxpayers cannot immediately deduct inventory costs when purchased. Instead, these costs are capitalized and later deducted through costs of goods sold when the inventory is actually sold.

So who has to use the accrual method? Generally, C corporations (other than qualified personal service corporations) must use the accrual method if their average annual gross receipts exceed $27 million. Other businesses may have to use the accrual method if they maintain inventory that is a material income-producing factor in their business.

General Charitable Deduction Rules for Property

With that understanding, we can turn to the charitable deduction rules. These rules are found in Section 170.

Section 170 provides for an income tax deduction for charitable contributions made during the tax year to qualifying organizations. For corporations, the deduction is generally limited to 10% of taxable income (with adjustments), with any excess carried forward for up to five years.

For property donations, additional requirements apply beyond those for cash donations. These include:

The property must be owned by the taxpayer at the time of contribution
The contribution must be complete and irrevocable
The property must be properly valued
For certain property valued over $5,000, a qualified appraisal is required
The taxpayer must maintain reliable written records of the contribution

The amount of the deduction depends on several factors, including the type of property donated and its potential tax treatment if sold.

When a business donates appreciated property to charity, there is a basis limitation that applies. Generally, the deduction is limited to the taxpayer’s basis in the property. However, if the property would have generated long-term capital gain if sold (such as stock held more than one year), the deduction is for fair market value. However, for inventory and other ordinary income property, the deduction is usually limited to basis. This is because inventory, by definition, generates ordinary income rather than capital gain when sold. The basis limitation prevents businesses from claiming a deduction for appreciation that would have been taxed as ordinary income if the inventory had been sold instead of donated.

This limitation on inventory donations created a disincentive for businesses to donate inventory to charitable organizations. Congress addressed this issue by adding Section 170(e)(3), which provides an enhanced deduction for certain inventory donations.

The Enhanced Deduction Under 170(e)(3)

Section 170(e)(3) provides an exception to this general rule. This deduction is only available for C corporations and is only helpful for those that are on the accrual method.

A C corporation can claim an enhanced deduction for inventory donations if:

The donation is to a public charity (not a private foundation);
The property will be used solely for care of the ill, needy, or infants;
The charity cannot charge for the donated items;
The donor receives a written statement from the charity confirming these requirements; and
If the property is regulated (like food or drugs), it meets applicable regulations.

The enhanced deduction amount is tax basis plus half of the appreciation. So the fair market value minus tax basis. These combined amounts cannot exceed twice the amount of the tax basis. This creates a significant opportunity for businesses with defective or obsolete inventory.

Definition of Ill, Needy, and Infant

To qualify for the enhanced deduction the property must be used solely for the care of the “ill, needy, or infants.” The regulations provide detailed definitions for each of these categories:

The regulations define an “ill person” as one requiring medical care. This includes individuals:

Suffering from physical injury
With significant impairment of a bodily organ
With an existing handicap (whether from birth or later injury)
Suffering from malnutrition
With a disease, sickness, or infection significantly impairing physical health
Partially or totally incapable of self-care (including due to old age)
With mental illness if hospitalized/institutionalized or if the illness constitutes a significant health impairment

A “needy person” is defined as one who lacks life’s necessities involving physical, mental, or emotional well-being due to poverty or temporary distress. Examples include:

Those financially impoverished due to low income
Individuals temporarily lacking food or shelter
Victims of natural disasters (like fires or floods)
Victims of civil disasters
Those temporarily not self-sufficient due to sudden crisis
Refugees or immigrants experiencing language, cultural, or financial difficulties
Former prisoners or mental institution patients who are not self-sufficient

The regulations define an “infant” as a minor child, as determined under the laws of the jurisdiction where the child resides. The “care of an infant” means performing parental functions and providing for the child’s physical, mental, and emotional needs.

It should be noted that the donated property must either be transferred directly to these individuals or retained for their care. No other person may use the contributed property except as incidental to the primary use in caring for the ill, needy, or infants. However, the charity may transfer the property to relatives, guardians, or other individuals if it makes reasonable efforts to ensure the property will primarily benefit the intended recipients.

An Example of the Numbers

Using and modifying the facts from the court case cited above as an example, let’s say the taxpayer established a public charity that provides hygiene products to the needy and donated its defective inventory to the charity. Assuming:

Inventory basis: $4.7 million
Fair market value (if not defective): $7 million

The potential enhanced deduction would be the lesser of:

Basis + 1/2 appreciation ($4.7M + $1.15M = $5.85M) or
2 × basis ($9.4M)

Here, the taxpayer could have claimed a $5.85 million deduction, significantly more than the $4.7 million tax basis that would be allowed to deduct as a reduction to costs of goods sold under the general rules.

However, the IRS may take issue with using defective inventory’s fair market value. The regulations suggest using the FMV at the time of contribution, so if the inventory is truly defective, its FMV might be much lower than $7 million. This could affect the calculation and could lead to a dispute with the IRS. This is why one has to take care to document the value if they are going to try to benefit from this enhanced tax deduction.

The Takeaway

The charitable deduction can mean that defective or obsolete inventory can have some value for taxpayers. For those that qualify, the enhanced charitable deduction under Section 170(e)(3) should be considered before simply writing these amounts off. While there are requirements to qualify, including getting proper documentation from the charity, this provision can turn a business challenge into an enhanced tax deduction while helping those in need. As with the taxpayer in this case, creating a charititable organization specifically for this purpose and tax planning can help unlock this benefit for just about any taxpayer.

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Stephan Dorsey

Stephan is the sports journalist for the Maple Grove Report.

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Signature Not Required on Tax Return for Criminal Liability – Houston Tax Attorneys

One of the requirements for a document to be a tax return is that it is signed by the taxpayer under penalties of perjury. Most tax forms that are intended to be tax returns include a declaration at the bottom that includes the penalty of perjury language.

But most tax returns today are filed electronically. Rather than signing with pen and ink, taxpayers sign online or authorize their tax preparers to use electronic signatures or PINs. The transmission or PIN is the signature.

This begs the question, what happens if the taxpayer goes to a tax preparer and there is no evidence that the taxpayer authorized the use of an electronic signature? Can the taxpayer be held liable for errors or omissions on this type of tax return? Can the taxpayer be charged criminally if the tax return is fraudulent? The recent United States v. Uvari, No. 2:18-cr-00253-APG-NJK-1 (9th Cir. Oct. 10, 2024), court case provides an opportunity to consider this question.

Facts & Procedural History

The taxpayer in this case was a professional gambler. He was charged with filing false tax returns. The court opinion does not say how the returns were fraudulent, but chances are good that there was either omitted income or inflated gambling losses.

The tax return at issue in this case was the taxpayer’s 2011 individual income tax return. The tax return was filed electronically by the taxpayer’s CPA. Rather than having the taxpayer’s physical signature, the return contained only a Personal Identification Number (“PIN”) and the CPA’s Electronic Return Originator (or “ERO”) PIN.

During the criminal tax trial, the government did not produce Form 8879, which is typically used to document a taxpayer’s authorization for electronic filing. The taxpayer was convicted and appealed, arguing in part that the government failed to prove he had verified the return under penalties of perjury.

Filing False Returns

Taxpayers are generally required to file income tax returns. If a return is required, it can be a crime to not file the tax return. But if the return is filed and it qualifies as a tax return, it can also be a crime if the tax return is false or fraudulent.

Section 7206 is the applicable criminal statute. It reads as follows:

Any person who: Willfully makes and subscribes any return, statement, or other document, which contains or is verified by a written declaration that it is made under the penalties of perjury, and which he does not believe to be true and correct as to every material matter; shall be guilty of a felony and, upon conviction thereof, shall be fined not more than $100,000 ($500,000 in the case of a corporation), or imprisoned not more than 3 years, or both, together with the costs of prosecution.

To prove a criminal violation for filing a false tax return under Section 7206(1), the government has to establish several elements. This includes showing that:

The defendant made and subscribed a return that was incorrect as to a material matter,
The return contained a written declaration that it was made under penalties of perjury,
The defendant did not believe the return to be true and correct, and
The defendant acted willfully with intent to violate the law.

This leads to the question as to what counts as a signature on a tax return?

What Counts as a “Signed” Return?

The traditional physical signature has largely given way to electronic filing. As the IRS agent testified in this case, “the IRS won’t receive a pen and ink signature from you in most cases. It’s always signed by a PIN.”

This can happen in two ways: either the taxpayer inputs their own PIN, or they authorize their tax preparer to enter a PIN on their behalf. In either case, there must be a declaration that the return is being signed under penalties of perjury. Typically, when a tax preparer files electronically on behalf of a taxpayer, they should obtain a signed Form 8879, which documents the taxpayer’s authorization to file electronically and use an electronic signature.

On the civil tax side of it, the courts have previously said that signing the Form 8879 does not transfer the obligation to file to the tax preparer and that the taxpayer still has to verify that the e-Filed return was received by the IRS. Thus, taxpayers cannot avoid the late filing penalty when a tax return is not received due to e-Filing mishaps.

This raises an interesting question: what happens when there is no Form 8879? Was the tax return actually filed if the process required for e-Filing was not followed? In this case, the government did not produce this form. This suggests that the form was never signed by the taxpayer. The absence of Form 8879 might seem to support a defense that the taxpayer never authorized the filing.

The Ninth Circuit court did not agree with this

The Ninth Circuit court did not agree with this. It concluded that the government need not produce Form 8879 if there is other evidence showing the taxpayer authorized the filing.

Other Evidence of Filing

While there wasn’t a Form 8879 in this case, there was other evidence that the taxpayer authorized the filing. The taxpayer wrote a letter to the IRS in 2017 regarding the 2011 tax return. It stated: “I e-filed the original Form 1040 for 2011 on or about February 1, 2012.” This letter was sent to the IRS by the taxpayer to get the IRS to process the tax return.

The government admitted the letter into evidence in the criminal trial. The court found that a reasonable jury could infer from this statement that the taxpayer either filed the return himself or authorized his accountant to file it. This after-the-fact acknowledgment of the filing was sufficient to establish that the taxpayer had verified the return under penalties of perjury.

Comparison to the Non-Criminal Tax Return Rules

The standards to impose criminal liability are generally higher than those on the civil side. This ruling by the court is consistent with the various court’s holdings as to the non-criminal tax return filing rules, but the court cases are varied based on whether the taxpayer benefits or does not benefit from there being a signature on the tax return.

The tacit consent cases provide an example. These cases involve joint tax returns filed by spouses. The cases generally stand for the proposition that one spouse can bind another spouse by signing their name on a tax return. These cases usually involve situations that benefit the IRS as they are cases where the IRS has more than one taxpayer on the hook if the signature is valid.

The signature requirement in cases involving disputes over civil penalties is similar. Signatures are not always required for liability to attach when it comes to civil penalties. For example, the courts have generally concluded that even the tax preparer’s fraud or bookkeeper’s fraud can in some cases be imputed to the taxpayer. Thus, a taxpayer can even be liable for civil penalties even if they did not have any fraudulent intent. This is apparently true even if the return is e-Filed and not formally signed by the taxpayer.

Compare this to the signature requirements for tax refunds

Compare this to the signature requirements for tax refunds. While a spouse can sign a joint tax return for the other spouse, a tax attorney acting under a valid power of attorney cannot sign a Form 843 refund claim for the taxpayer-client. The rules are a little more nuanced than this for refund cases, however.

At least one court has said that if the IRS audits a refund claim and does not require a signature on the return, the IRS can waive the requirement that the taxpayer sign the return by processing the return without a signature. While these refund cases usually benefit taxpayers as if the signature is valid the tax refund can be processed and refunds issued, there are exceptions.

The Takeaway

Signature issues abound when it comes to tax returns. The general rule is that signatures are less important when the facts and circumstances are that not having a signature benefits the taxpayer. When the taxpayer needs a signature to obtain some advantage or benefit, the rules are more strict. That lesson is presented again in this case. As explained by this case, taxpayers cannot always escape criminal liability for false returns if they did not physically sign the tax return. This is true even if the tax preparer failed to obtain Form 8879 signed by the taxpayer. The taxpayer’s own subsequent acknowledgment of the filing can supply the requisite authorization and count as a signature under penalties of perjury.