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Individual Tax

IRS Releases Proposed Reliance Regs on SALT Limitation Workarounds

Thomson Reuters Tax & Accounting  

Thomson Reuters Tax & Accounting  

The IRS has released proposed regs on how to treat contributions made to a charity in return for state and local tax (SALT) credits. These proposed regs include guidance on

  1. The treatment of business entity payments to charitable entities;
  2. The treatment of payments by individuals with total state and local tax liabilities less than or equal to the $10,000 limitation; and
  3. The application of the “quid pro quo” principle to benefits received or expected to be received by the donor from a party other than the donee.

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))

However, Reg §1.162-15(a)(2) clarifies that the limitations in Reg §1.162-15(a)(1) apply only to payments that are in fact contributions or gifts to a Code Sec. 170 entity. For example, under Reg §1.162-15(a)(2) payments by a transit company to a local hospital that is a Code Sec. 170 entity in consideration of a binding obligation on the part of the hospital to provide hospital services and facilities for the transit company’s employees are not contributions or gifts under Code Sec. 170 and may be deductible under Code Sec. 162(a) if the requirements of that section are otherwise satisfied.

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 includes:

  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. In response to these tax planning strategies, the IRS has issued various forms of guidance, including proposed (Preamble to Prop Reg REG-112176-18) and final (TD 9864) regs. (Preamble to Prop Reg REG-107431-19)

In June 2018, the IRS announced that it would propose regs addressing the proper application of Code Sec. 164 and Code Sec. 170 to taxpayers who make contributions under SALT credit programs to a governmental entity and/or charity. (Notice 2018-54, 2018-24 IRB 750) See IRS to issue regs on workarounds adopted by states to avoid limit on State and local tax deduction (05/24/2018).

In August 2018, the IRS proposed amending Reg §1.170A-1(h)(3) (Preamble to Prop Reg REG-112176-18) 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 (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 address contributions made in exchange for SALT credits (08/24/2018).

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 published final regs (the final regs, T.D. 9864). The final regs retained the rules set out in the 2018 proposed regs, with certain clarifying and technical changes. Most significantly, the final regs retained the general rule that, if a taxpayer makes a payment or transfers property to or for the use of a governmental entity or charity, and the taxpayer receives or expects to receive a state or local tax credit in return for such transfer, the tax credit constitutes a return benefit to the taxpayer, or quid pro quo, reducing the taxpayer’s charitable contribution deduction. (Reg §1.170A-1(h)(3)) See IRS issues final regs & safe harbor on charitable contributions and SALT credits (06/12/2019; subscription required).

On the same day, the IRS issued Notice 2019-12, 2019-27 IRB 57, which provided 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).

New proposed regs. The new proposed regs provide guidance on three issues that remain unclear despite previous guidance. These issues are:

  1. The treatment of business entity payments to entities described in Code Sec. 170(c);
  2. The treatment of payments by individuals with total state and local tax liabilities that were less than or equal to the Code Sec.164(b)(6) limitation; and
  3. Application of the quid pro quo principle under Code Sec. 170 to benefits received or expected to be received by the donor from a party other than the done.

Treatment of business entity payments to a governmental entity or charity. The new proposed regs would amend Reg §1.162-15(a) to incorporate the safe harbors in Rev Proc 2019-12. The proposed regs would also amend Reg §1.170A-1(c)(5) and Reg §1.170A-1(h)(3)(viii) to provide cross references to Reg 1.162-15(a). In addition, the proposed regs would make additional revisions to Reg §1.162-15(a) to more clearly reflect the current state of the law regarding a taxpayer’s payment or transfer to a governmental entity or charity. If the taxpayer’s payment or transfer bears a direct relationship to its trade or business, and the payment is made with reasonable expectation of commensurate financial return, the payment or transfer may constitute an allowable deduction as a trade or business expense rather than as a charitable contribution. (Preamble to Prop Reg REG-107431-19)

The proposed regs include an example that illustrates that this rule would apply regardless of whether the taxpayer expects to receive a SALT tax credit in return. (Preamble to Prop Reg REG-107431-19)

In addition, the proposed regs would add a cross-reference to Reg §1.170A-1(h) (payments to governmental entities and charities in exchange for consideration), which provides more detailed rules for determining whether a payment or a portion of a payment to a governmental entity or charity may be deducted as a business expense under Code Sec. 162(a) or a charitable deduction under Code Sec. 170(a). (Preamble to Prop Reg REG-107431-19)

Payments by individual in exchange for SALT credits . To alleviate concerns that Notice 2019-12 did not fully address the tax consequences to individuals who received or expected to receive SALT credits, the IRS proposes to add Reg §1.164-3(j) to provide a safe harbor for individuals who make payment to or for the use of a governmental entity or charity in return for a SALT credit. The proposed regs would also add Reg §1.170A-1(h)(3) to provide a cross reference to the safe harbor in Prop Reg §1.164-3(j). (Preamble to Prop Reg REG-107431-19)

Under the proposed regs, an individual who itemizes deductions and makes a payment to a governmental entity or charity in exchange for a SALT credit would be able to treat as a SALT payment the portion of such payment that would be disallowed as a charitable contribution under Reg §1.170A-1(h)(3). This treatment would be allowed in the tax year in which the payment is made, but only to the extent that the resulting credit is applied pursuant to applicable state or local law to offset the individual’s SALT liability for such tax year or the preceding tax year. Any unused credit permitted to be carried forward may be treated as a SALT payment in the tax year or years for which the carryover credit is applied under state or local law. The safe harbor for individuals applies only to payments of cash and cash equivalents. (Preamble to Prop Reg REG-107431-19)

The proposed regs are not intended to permit a taxpayer to avoid the Code Sec. 164(b)(6) limitations. Therefore, the proposed regs provide that any payment treated as a SALT payment under the safe harbor provided in Prop Reg §1.164-3(j) would be subject to the limitations on SALT deduction. (Preamble to Prop Reg REG-107431-19)

Furthermore, the proposed regs are not intended to permit deductions of the same payments under more than one provision. Thus, the proposed regs would provide that an individual who relies on the safe harbor in Prop Reg §1.164-3(j) to deduct qualifying payments under Code Sec. 164 may not also deduct the same payments under any other Code section. (Preamble to Prop Reg REG-107431-19)

Consideration provided by party other than the donee. The IRS proposes to amend Reg §1.170A-1(h)(4) to provide definitions of “in consideration for” and “goods and services” for purposes of applying the rules in Prop Reg §1.170A-1(h). Under the proposed regs, a taxpayer would be treated as receiving goods and services in consideration for a taxpayer’s payment or transfer to a governmental entity or charity if, at the time the taxpayer makes the payment or transfer, the taxpayer receives or expects to receive goods or services in return. (Preamble to Prop Reg REG-107431-19)

The proposed regs do not amend the language of Reg §1.170A-13(f)(6), which discusses “in consideration for” for purposes of determining whether the taxpayer provides proper substantiation of its charitable contribution. (Preamble to Prop Reg REG-107431-19)

The proposed regs amend the language in Reg §1.170A-1(h)(2)(i)(B) to clarify that the fair market value of goods and services would include the value of goods and services provided by parties other than the donee. Also, the proposed regs adds a definition of “goods and services” that is the same as the definition in Reg §1.170A-13(f)(5). Finally, the proposed regs revises 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 Prop Reg §1.170A-1(h)(4).

Proposed applicability dates. The proposed amendments contained in Prop Reg §1.162-15(a)(1) and Prop Reg §1.162-15(a)(2) and Prop Reg §1.170A1(c)(5), regarding the application of Code Sec. 162 to taxpayers that make payments or transfers to entities described in Code Sec. 170(c), are proposed to apply to payments or transfers on or after December 17, 2019. However, a taxpayer may rely on these proposed regs for payments and transfers made on or after January 1, 2018 and before regs finalizing these proposals are published in the Federal Register. (Prop Reg §1.162-15(a)(4))

The proposed amendment contained in Prop Reg §1.162-15(a)(3), regarding safe harbors for entities making payments to or for the use of Code Sec. 170(c) entities in exchange for SALT credits, is proposed to apply to payments on or after December 17, 2019. However, a taxpayer may continue to apply Rev. Proc. 2019-12, which applies to payments made on or after January 1, 2018, for payments made before December 17, 2019. (Prop Reg §1.162-15(a)(4))

The proposed amendments contained in Prop Reg §1.164-3(j) and Prop Reg §1.170A-1(h)(3)(ix), regarding the safe harbor for payments by certain individuals to or for the use of Code Sec. 170(c) entities, are proposed to apply to payments made on or after June 11, 2019. However, individuals may rely on these proposed regs for payments made after August 27, 2018, the applicability date of the final regs, and before the regs finalizing these proposed regs are published in the Federal Register. (Prop Reg §1.164-3(j)(7))

Finally, the proposed amendments contained in Prop Reg §1.170A-1(h)(1), Prop Reg §1.170A-1(h)(2)(i)(B), Prop Reg §1.170A-1(h)(3)(iii), Prop Reg §1.170A-1(h)(4)(i), Prop Reg §1.170A-1, and Prop Reg §1.170A-13(f)(7) clarifying “in consideration for” for purposes of applying Prop Reg §1.170A-1(h) are proposed to apply to payments or transfers on or after December 17, 2019. (Prop Reg §1.170A-1(h)(4)(iii))

References: For 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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