The following is information about tax deductions of pharmaceutical drugs when they are donations. In addition to reviewing the code and regulations, I relied upon information from Gerald Auten, Office of Tax Analysis, Department of the Treasury (ph.202.622.1792 gerald.auten@do.treas.gov).

I. Legal basis for deduction

The statutory basis for tax deductions of pharmaceutical drugs is Internal Revenue Code (IRC)Section 170 (e) (3). Additional applicable regulations are in IRS Reg. 1.170A-4 and 5.

II. How does it work?

Generally, the deduction for donations of goods out of the inventory of a business is limited to the cost or basis of the goods. This is more restrictive than donations of appreciated capital gain property (such as corporate stock), where the donor can deduct the full market value even if it exceeds the cost.

Under Section 170(e)(3), tax deductions for qualified contributions of pharmaceutical drugs can qualify for an *enhanced deduction* that is more generous than the deduction that would be allowed under the general rules for donating inventory.

If the donation meets the conditions explained below, the enhanced deduction will be based upon the lesser of (1) the cost basis plus half the difference between cost and fair market value (FMV), and (2) twice the cost basis.

For example

1) Suppose the cost of product is $200 and the market value is $500. The difference between cost and FMV is $300 and half of the difference is $150. The deduction would be $200+$150=$350. This is less than twice the cost basis.

2) Suppose the cost is $200 and the market value $1000. The difference between cost and FMV is $800 and half the difference is $400. Cost plus half the difference is $200 +$400 = $600. Since this exceeds the "maximum twice the cost rule," the deduction would be limited to $200 x 2 = $400.

III. What are the conditions?

Pharmaceuticals, if they meet several provisions including the following basic conditions:

-the donated product is used solely for the care of the ill, needy or infants
-taxpayer has to get a written statement by the donee stating that the donation is to be used for qualified purposes.
-the charitable organization must be a US 501(c)(3) charitable organization, but can transfer the drugs to another exempt US organization, or a non-US organization that would meet the standards if it were a US exempt organization.
-the donation must be by a C Corporation (one that pays the corporate income tax, not "any" business, such as a partnership, or an individual)
-the donated product comply with FDA rules (such as expiration dates).

IV. How much is the deduction worth?

The financial incentive for corporations could be explained as follows: The maximum US corporate tax rate is 35%. A corporation is able to deduct up to twice its cost basis. Thus, the deduction would lower US income tax by up to 70 percent of the cost basis.

V. How does the cost basis compare to actual production costs?

The cost basis is based upon standard inventory valuation rules for the cost of goods. It typically does not include R&D expenses, and does not include marketing and administrative costs.

However, with economies of scale, the inventory cost basis may be considerably higher than "marginal" costs of production, since many "costs of goods" costs are fixed, or have increasing returns to scale. Thus, in many cases the tax subsidy of 70 percent of the average cost of goods, can be much higher than the marginal costs of producing the drugs for the donation.