The IRS has issued final regs on workarounds whereby taxpayers make contributions to charities in return for state-provided state and local tax (SALT) credits.
Background.
Generally, Code Sec. 170(a)(1) allows an itemized deduction for any “charitable contribution” paid within the tax year. A “charitable contribution” is a “contribution or gift to or for the use of” entities described in Code Sec. 170(c).
Under Code Sec. 170(c)(1), such entities include a State, a possession of the United States, or any political subdivision of the foregoing, or the District of Columbia. Under Code Sec. 170(c)(2) such entities include certain corporations, trusts, or community chests, funds, or foundations, organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes, or to foster national or international amateur sports competition, or for the prevention of cruelty to children or animals. Collectively, these are referred to as Code Sec. 170 entities.
Reg § 1.170A-1(c)(5) provides that transfers of property to a Code Sec. 170 entity that (1) bear a direct relationship to the taxpayer’s trade or business, and (2) are made with a reasonable expectation of financial return commensurate with the amount of the transfer, may be deducted as trade or business expenses rather than as charitable contributions.
Code Sec. 162(a) allows a deduction for all the ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business. However, under Code Sec. 162(b) no deduction is allowed under Code Sec. 162(a) for any contribution or gift that would be allowable as a charitable contribution deduction but for the percentage limitations, the dollar limitations, or the requirements as to the time of payment in Code Sec. 170. (Reg § 1.162-15(a)(1))
Code Sec. 164(b)(6), as added by section 11042(a) of the Tax Cuts and Jobs Act (TCJA, PL 115-97) provides that an individual’s deduction for SALT paid during a calendar year is limited to $10,000. The $10,000 limit applies to: (1) real property taxes; (2) personal property taxes; (3) income war profits and excess profits taxes; and (4) general sales taxes. This limitation applies to tax years beginning after December 31, 2017, and before January 1, 2026. The $10,000 SALT limit does not include foreign taxes or state and local taxes that are paid or accrued in carrying on a trade or business or an investment activity.
In response to the limitation in Code Sec. 164(b)(6), some taxpayers have considered tax planning strategies to avoid or mitigate its effects. Some of these strategies rely on SALT credit programs under which states provide tax credits in return for contributions to certain charitable entities, contributions to which are tax deductible under Code Sec. 170. (Preamble to TD 9907)
In August 2018, the IRS proposed amending Reg §1.170A-1(h)(3) to provide, in general, that if a taxpayer makes a payment or transfers property to or for the use of a governmental entity and/or charity and the taxpayer receives or expects to receive a SALT credit in return for such payment or transfer, the tax credit constitutes a return benefit to the taxpayer and reduces the taxpayer’s charitable contribution deduction. (Prop Reg REG-112176-18; “2018 proposed regs”).
According to their preamble, the 2018 proposed regs were premised, in part, on the quid pro quo principle articulated in American Bar Endowment, (S Ct 1986) 58 AFTR 2d 86-5190, that “a payment of money generally cannot constitute a charitable deduction if the contributor expects a substantial benefit in return.” The 2018 proposed regs also proposed amending regs under Code Sec. 642(c), to provide a similar rule for payments made by a trust or decedent’s estate. See Proposed regs would eliminate benefit of SALT limitation workaround (08/27/2018).
In December 2018, the IRS issued Rev Proc 2019-12, 2019-4 IRB 401, which provides that, to the extent a C corporation receives or expects to receive a SALT credit in return for a payment to a governmental entity or charity, it is reasonable to conclude that there is a direct benefit and a reasonable expectation of commensurate financial return to the C corporation’s business in the form of a reduction in the state or local taxes the C corporation would otherwise be required to pay. Thus, the procedure provides a safe harbor that allows a C corporation engaged in a trade or business to treat the portion of the payment that is equal to the amount of the credit received or expected to be received as meeting the requirements of an ordinary and necessary business expense under Code Sec. 162. See IRS: Sec. 162 deduction available for payment by businesses to reduce certain state taxes (12/31/2018).
In June 2019, the IRS issued Notice 2019-12, 2019-27 IRB 57, which provides a safe harbor under Code Sec. 164 for certain individuals who make a payment to, or for the use of, a governmental entity or charity in return for a SALT credit. See Safe harbor provision for charity payment made in return for SALT credit (06/13/2019).
In December 2019, the IRS issued proposed regs under Code Sec. 162, Code Sec. 164, and Code Sec. 170 that included the safe harbors provided under Rev Proc 2019-12 and Notice 2019-12, updated regs under Code Sec. 162 to reflect current law regarding the application of Code Sec. 162 to a taxpayer that makes a payment or transfer to an entity described in Code Sec. 170(c) for a business purpose, and clarified the application of the quid pro quo principle under Code Sec. 170 to benefits received or expected to be received from third parties. (REG-107431-19, the 2019 proposed regs) See IRS releases proposed reliance regs on SALT limitation workarounds (12/17/2019).
Final regs.
The IRS adopts the 2019 proposed regs with clarifications. (Preamble to TD 9907).
The final regs retain the proposed amendments to the regs under Code Sec. 170 to reflect past guidance and case law regarding the application of the quid pro quo principle under Code Sec. 170 to a donor who receives or expects to receive benefits from a third party. (Preamble to TD 9907)
But, to reflect existing law, the final regs amend the rules in Reg. §1.170A-1(h) that address a donor’s payments in exchange for consideration. Specifically, the final regs revise Reg §1.170A-1(h)(4) to provide definitions of “in consideration for” and “goods and services” for purposes of applying the rules in Reg. §1.170A-1(h). Under the final reg, a taxpayer will be treated as receiving goods and services in consideration for a taxpayer’s payment or transfer to an entity described in Code Sec. 170(c) if, at the time the taxpayer makes the payment or transfer, the taxpayer receives or expects to receive goods or services in return. (Reg §1.170A-1(h)(4)(i))
For additional clarity, the final regs amend the language in Reg. §1.170A-1(h)(2)(i)(B) to state that the fair market value of goods and services includes the value of goods and services provided by parties other than the donee. Also, the final regs add a definition of “goods and services” that is the same as the definition in Reg. §1.170A-13(f)(5).
Finally, the final regs revise the cross-references defining “in consideration for” and “goods and services” in Reg. §1.170A-1(h)(1) and Reg. §1.170A-1(h)(3)(iii) to be consistent with the definitions provided in Reg. §1.170A-1(h)(4).
Applicability date.
The amendments to Reg. §1.162-15 apply to payments or transfers made on or after December 17, 2019. However, taxpayers may choose to apply the amendments to payments or transfers made on or after January 1, 2018. (Reg. §1.162-15(a)(4)))
Reg. §1.164-3(j) applies to payments made to Code Sec. 170(c) entities on or after June 11, 2019. However, taxpayers may choose to apply it to payments made to Code Sec. 170(c) entities after August 27, 2018. (Reg. §1.164-3(j)(7))
The definitions provided in Reg. §1.170A-1(h)(4) are applicable to amounts paid or property transferred on or after December 17, 2019. (Reg. §1.170A-1(h)(4)(iii))
To continue your research on the deduction for state and local taxes, see FTC 2d/FIN ¶K-4500; United States Tax Reporter ¶1644.03. For the deduction for charitable contributions, see FTC 2d/FIN ¶K-2800; United States Tax Reporter ¶1704.38.
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