Recent presidential impeachment hearings have raised the Latin phrase quid pro quo to national attention. What does it mean? The literal meaning of quid pro quo is “something for something.” Put differently, a quid pro quo exists when something is given in exchange for something else. In Thanksgiving parlance, quid pro quo may mean a person better bring a dish (or two) to share at the holiday table! For nonprofits, this term applies to charitable contributions and payments for goods and services, with critical distinctions affecting tax deductibility, tax receipting, and potential “private benefit” tax issues. This article provides a helpful primer on these important tax issues with a special holiday spin.
Ending Hunger – A Worthy Cause!
Consider Ending Hunger, a fictional Section 501(c)(3) public charity dedicated to providing food for the hungry throughout the U.S. Every year, Ending Hunger conducts a Thanksgiving fundraising campaign. The organization gives a free turkey to any donor who contributes at least $5,000 during the month of November. Donor Debbie does so, giving $6,000 to Ending Hunger. How should Ending Hunger acknowledge Debbie’s charitable contribution? Is this gift tax deductible? To answer these questions, three key considerations should be addressed, with one important “insubstantiality” caveat.
1. Does Ending Hunger Qualify as a Permissible Donee?
Yes, Ending Hunger is a Section 501(c)(3) tax-exempt organization. The Tax Code restricts qualifying donees to such entities along with certain other organizations, but not Section 501(c)(4) “action” organizations, Section 501(c)(6) trade associations, or Section 501(c)(7) social clubs.
2. Does Debbie’s Payment to Ending Hunger Constitute a Contribution or Gift?
This question can pose more challenges, depending on the circumstances. Under the applicable two-part tax test, Debbie must intend to make a payment to Ending Hunger in an amount that exceeds the fair market value of the return benefit (quid pro quo). In addition, Debbie must actually make a payment in an amount that exceeds the fair market value of the return benefit. (See U.S. Treas. Reg. Section 1.170A-1(h)(1)). If she intended to and does in fact contribute an amount that exceeds the value of the return benefit, she can claim a charitable deduction for the additional amount. The return benefit is in the nature of a quid pro quo, so its value cannot qualify for a federal income tax deduction.
Let’s assume Debbie’s intent is to make a gift to Ending Hunger. She makes a charitable contribution of $6,000. Ending Hunger gives Debbie an expertly smoked, beautifully flavored turkey with a fair market value of $100, the envy of her neighbors and friends (who all aspire to tasting it too). The tax deductible portion of Debbie’s $6,000 contribution is reduced by the $100 FMV of the turkey.
But an important exception may apply here, effectively erasing any quid pro quo related tax consequences: the “insubstantial value” rule. Under this exception, a donor’s receipt of goods or services with “insubstantial” fair market value which are provided in return for a charitable contribution are disregarded for purposes of determining the donor’s deductible contribution. (See Rev. Proc. 90-12, as amplified, modified, and supplemented). In other words, the contribution will be treated as if there were no quid pro quo involved here at all.
Here, Debbie just wants to be generous, and the delicious turkey is simply a “thank you” without any strings, conditions, or other significant motivating factor for Debbie’s gift. That conclusion makes sense. After all, if Debbie is well resourced enough to make a $6,000 gift, surely, she can go pick out her own gourmet turkey.
The question of insubstantiality is answered both relatively and concretely, based on satisfying the following requirements (and adjusted annually for inflation):
- The benefits are received in the context of a charitable fundraising campaign in which the charity informs potential donors how much of their payment is a deductible contribution; and
- The fair market value of all of the benefits received in connection with the contribution is not more than the lesser of 2% of the donation or $111.[1]
Here, the value of Debbie’s turkey is less than both the $111 limit and 2% of her charitable contribution (e.g. $120 for a $6,000 contribution).
3. Substantiating the Contribution
Per the above scenario, Debbie’s yummy turkey thus qualifies as a benefit with insubstantial value and may be disregarded for purposes of determining her deductible contribution. She not only eats well, but she gets the full $6,000 deduction – no quid pro quo (for tax purposes, anyway)! Ending Hunger’s written substantiation is essential to such tax treatment, as follows:
Thanks, Debbie, for your November 2019 tax-deductible gift of $6,000 to Ending Hunger, which is a tax-exempt public charity under Section 501(c)(3) of the Internal Revenue Code. Under Internal Revenue Service guidelines, the estimated value of the benefits received is insubstantial; therefore the full amount of your payment is deductible.
Now consider a new donation example: What about Bob? His donation is only $400 and he also gets a turkey. A different result occurs for him, since his gift does not qualify for the above “insubstantial value” exception. Per Internal Revenue Code Section 6115(a), if an organization receives a quid pro quo contribution in excess of $75, it must “provide a written statement which: (a) informs the donor that the amount of the contribution that is deductible for federal income tax purposes is limited to the excess of the amount of any money and the value of any property other than money contributed by the donor over the value of the goods or services provided by the organization; and (b) provide the donor with a good faith estimate of the value of such goods or services.
Under this alternative example and again assuming that each turkey’s fair market value is $100, Ending Hunger must provide a written receipt to Bob, setting forth the $100 FMV and stating that his deductible contribution for federal income tax purposes is limited to the excess $300 contribution amount – i.e., only the amount above the quid pro quo turkey benefit. The following language would satisfy such tax substantiation requirements:
Thanks, Bob, for your November 2019 tax-deductible gift of $400 to Ending Hunger, which is a tax-exempt public charity under Section 501(c)(3) of the Internal Revenue Code. A turkey was provided to you as a result of your contribution, with a good faith estimated value of $100. The remaining amount of $300, for which no goods or services were provided to you as a result of your contribution, is a tax-deductible charitable contribution.
The Tax Plot Twist – Turkey Trouble
Assume now that Ending Hunger’s executive director Ed is an old friend of Tom, the CEO of Turkey Co. Tom needs to please his Turkey Co. shareholders with year-end profits, so he proposes to sell all the turkeys to Ending Hunger. Ed agrees and, since they are such great friends, further agrees to pay 50% more per turkey – $150 per bird. Is Tom a friend indeed, or is he trouble for Ed and Ending Hunger? The answer depends yet again on the quid pro quo question.
As a Section 501(c)(3) nonprofit, Ending Hunger must operate “exclusively” for tax-exempt purposes, meaning that it must serve public interests (i.e., helping the hungry) rather than private interests (i.e., Ed and Turkey Co.). This requirement is not an absolute bar on transacting with private persons. To the contrary, charities often make payments in exchange for goods or services required for carrying out their programs and activities. Such payments are often legitimate quid pro quo arrangements – payment for something of equivalent value. Any benefit to a private individual or entity from the exempt organization’s operations is merely “incidental” to the public benefit offered by the organization. The compensation paid by Ending Hunger must be objectively fair, reasonable, and commensurate with the goods or services provided, so that the private benefit to Turkey Co. and Tom is only incidental to Ending Hunger’s charitable provision of food to those in need.
Such transactions with private persons necessarily result in some private benefit to the recipient. For example, if Ending Hunger buys turkeys at the $100 fair price from Turkey Co., Turkey Co. will receive money and Tom’s year-end profit goals will be advanced. All is fair and legitimate, so the resulting private benefit is entirely permissible.
But the 50% mark-up? No. Such private benefit is substantial and lacks appropriate justification. Consequently, it amounts to an “impermissible private benefit.” Not only does that mean that Tom is really a bad friend, but it also constitutes grounds for revocation of Ending Hunger’s tax-exempt status.
Operating for public benefit is essential for continued Section 501(c)(3) tax-exempt status; providing private benefits beyond legitimate quid pro quo transactions could spell the end for Ending Hunger. Lessons learned? Better stick to donated turkeys, if possible, careful tax receipting, and tax compliant application of quid pro quo rules. And remember – no politics at the Thanksgiving table!
[1] Additional exceptions may apply for low-cost token items, membership benefits, and corporate sponsorships.
