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Info letter spells out effect of recent proposed regs on state’s tax credit program

October 8, 2018

IRS has issued an information letter in which it provides that a state tax credit program, to which business taxpayers can make payments in exchange for credits against various business taxes, is not impacted by the recent proposed regs targeting state and local tax (SALT) limitation workarounds.

Background—business expense deduction. Generally, a taxpayer may deduct ordinary and necessary business expenses paid or incurred during the tax year in carrying on a trade or business. (Code Sec. 162(a)) An expense is ordinary if it is customary or usual within a particular trade, business or industry or relates to a common or frequent transaction in the type of business involved. A necessary expense is appropriate and helpful to the operation of the taxpayer’s trade or business.

Background—charitable contribution deduction.  Code Sec. 170(a)(1) generally allows an itemized deduction for any “charitable contribution” paid within the tax year. Code Sec. 170(c) defines “charitable contribution” as a “contribution or gift to or for the use of” any entity listed in that subsection. Code Sec. 170(c)(1) includes a contribution or gift to or for the use of a State, a possession of the U.S., or any political subdivision of the foregoing, but only if the contribution or gift is made exclusively for public purposes.

Background—SALT deduction. For tax years beginning after 2017 and before 2026, the Tax Cuts and Jobs Act (TCJA; P.L. 115-97, 12/22/2017) amended Code Sec. 164(b)(6) to limit individual annual SALT deductions to a maximum of $10,000, with no carryover for taxes paid in excess of that amount. As a result of this change, many taxpayers will not get a full federal income tax deduction for their payments of state and local taxes. The SALT deduction limit doesn’t apply to property taxes paid in connection with a trade or business or in connection with the production of income. (Code Sec. 164(b)(6))

Following the TCJA’s passage, certain state legislatures—specifically, those of several high-tax states—implemented workarounds to mitigate the effect of the new Code Sec. 164(b)(6) SALT deduction limit for their residents, including the establishment of charitable funds to which taxpayers can contribute and receive a tax credit in exchange.

In response, IRS issued proposed regs that would effectively eliminate the benefit of these workarounds. See “Proposed regs would eliminate benefit of SALT limitation workaround.” Specifically, the proposed regs would require a taxpayer that makes a payment or transfers property to an entity described in Code Sec. 170(c) to reduce its charitable contribution deduction by the amount of any state or local tax credit the taxpayer receives or expects to receive.

IRS subsequently issued a news release providing that taxpayers who make business-related payments to charities or government entities for which they receive SALT credits can continue to claim business expense deductions for these payments. (IR 2018-178; see “Prop regs targeting SALT limitation workarounds don’t affect deductability of business payments.”)

Shortly after issuing IR 2018-178, IRS issued a single FAQ providing that the proposed regs address “the deductibility of contributions in exchange for state and local tax credits as charitable contributions,” and do not “affect the availability of a business expense deduction under Code Sec. 162.” (See “IRS issues FAQ, and Mnuchin issues statement, on SALT limitation.”)

Facts. Business taxpayers in State pay amounts pursuant to a state tax credit program that provides credits against business taxes, such as insurance premium tax, direct pay sales and use tax, corporate income tax, alcoholic beverage excise tax, oil and/or gas production tax, and state sales tax due on rent or license fee payments.

IRS received a letter requesting information on the potential effect of the proposed regs on the tax treatment of these amounts.

IRS response. In the Information Letter, IRS described the proposed regs as addressing only the deductibility of certain amounts as charitable contributions under Code Sec. 170 (or Code Sec. 642, if made by a trust or decedent’s estate).

Accordingly, IRS clarified that a business taxpayer’s payments under State’s tax credit program that are deductible under any other Code section would not be impacted by the proposed regs.

Checkmark Observation: It remains unclear under this and other previous guidance  whether and to what extent payments to charities or government entities for which the payor receives SALT credits are “business-related payments” or whether and to what extent such payments “qualify as an ordinary and necessary business expense.”

References: For the deduction for state and local taxes, see FTC 2d/FIN ¶ K-4500United States Tax Reporter ¶ 1644.03. For ordinary and necessary business expenses, see FTC 2d/FIN ¶L-1200United States Tax Reporter ¶1624. For the deduction for charitable contributions, see FTC 2d/FIN ¶ K-2800United States Tax Reporter ¶ 1704.