Preamble to Prop Reg REG-112176-18; Prop Reg § 1.170A-1, Prop Reg § 1.170A-13, Prop Reg § 1.642(c)-3; IR 2018-172
In proposed regs, and an accompanying News Release, IRS has provided rules under which the amount otherwise deductible as a charitable contribution would generally be reduced by the amount of any state or local tax (SALT) credit received or expected to be received by the contributing taxpayer.
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.
The Supreme Court has held that a charitable contribution must be a transfer of money or property without adequate consideration—that is, without the expectation of a quid pro quo. (American Bar Endowment (S Ct 1986) 58 AFTR 2d 86-5190) Reg. § 170A-1(h)(1) provides that no part of a payment that a taxpayer makes to or for the use of an organization described in Code Sec. 170(c) that is in consideration for goods or services is a contribution or gift within the meaning of Code Sec. 170(c) unless the taxpayer (i) intends to make a payment in an amount that exceeds the fair market value of the goods or services; and (ii) makes a payment in an amount that exceeds the fair market value of the goods or services.
Background—deduction for state and local taxes. 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. The SALT deduction limit doesn’t apply to taxes paid in connection with a trade or business or in connection with the production of income. (Code Sec. 164(b)(6)) 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.
While federal law limits the deduction for an individual’s charitable contributions, the limits are generally much higher than $10,000 (see Code Sec. 170(b)(1)), and there is a carryover of charitable contributions that exceed the charitable deduction limits. (Code Sec. 170(d)(1))
Background—state local tax credit programs. In recent years, it has become increasingly common for states and localities to provide state or local tax credits in return for contributions by taxpayers to or for the use of certain entities listed in Code Sec. 170(c).
Chief Counsel Advice 201105010 observed that a payment to a state agency or charitable organization in return for a tax credit might be characterized as either a charitable contribution deductible under Code Sec. 170 or a payment of state tax possibly deductible under Code Sec. 164. The CCA advised that taxpayers may take a deduction under Code Sec. 170 for the full amount of a contribution made in return for a state tax credit, without subtracting the value of the credit received in return. According to the Preamble to the proposed regs, the analysis in the CCA assumed that after the taxpayer applied the state or local tax credit to reduce the taxpayer’s state or local tax liability, the taxpayer would receive a smaller deduction for state and local taxes under Code Sec. 164.
In addition to the CCA, IRS Chief Counsel has taken the position in the Tax Court that the amount of a state or local tax credit that reduces a tax liability is not an accession to wealth under Code Sec. 61 or an amount realized for purposes of Code Sec. 1001, and the Tax Court has accepted this view. (Maines, (2015) 144 TC 123)
Almost immediately after the TCJA’s passage, certain state legislatures—specifically, those of high-tax states—began looking for ways to mitigate the effect of the new Code Sec. 164(b)(6) SALT deduction limit for their residents.
A number of states implemented workarounds to the deduction limit. For example, New York established new “charitable gifts trust funds” to which taxpayers can make deductible contributions and claim a tax credit equal to 85% of the donation. Similarly, New Jersey enacted legislation that permits localities to establish charitable funds to which taxpayers can contribute and receive a 90% New Jersey property tax credit.
Background—Notice 2018-54. In May, 2018, in Notice 2018-54, 2018-24 IRB 750, IRS informed taxpayers that it intended to propose regs addressing the federal income tax treatment of certain payments made by taxpayers to state-established charitable funds for which they receive a credit against their state and local taxes. IRS indicated that the characterization of these payments would be determined under the Code, informed by substance-over-form principles and not the label assigned by the state.
Proposed regs eliminate benefit of workarounds. IRS has concluded—”in light of the longstanding principles of the cases and tax regs discussed above,” and after noting that the application of Code Sec. 61 and Code Sec. 1001 to state or local tax credits presents different issues than the application of Code Sec. 170—that when a taxpayer receives or expects to receive a state or local tax credit in return for a payment or transfer to an entity listed in Code Sec. 170(c), the receipt of this tax benefit constitutes a quid pro quo that may preclude a full deduction under Code Sec. 170(a). (Preamble to Prop Reg REG-112176-18)
Therefore, under the proposed regs, a taxpayer who makes payments or transfers property to an entity eligible to receive tax deductible contributions would have to reduce its charitable deduction by the amount of any state or local tax credit the taxpayer receives or expects to receive. (Prop Reg § 1.170A-1(h)(3)(i)) For example, if a state grants a 70% state tax credit and the taxpayer pays $1,000 to an eligible entity, the taxpayer receives a $700 state tax credit. The taxpayer would have to reduce the $1,000 contribution by the $700 state tax credit, leaving an allowable contribution deduction of $300 on the taxpayer’s federal income tax return. (Prop Reg § 1.170A-1(h)(3)(vii), Example 1)
The rule of Prop Reg § 1.170A-1(h)(3)(i) would not apply to dollar-for-dollar state tax deductions. (Prop Reg § 1.170A-1(h)(3)(ii)(A)) IRS said that, although deductions could be considered quid pro quo benefits in the same manner as credits, it believes that sound policy considerations, as well as considerations of efficient tax administration, warrant making an exception to quid pro quo principles in the case of dollar-for-dollar state or local tax deductions. Because the benefit of a dollar-for-dollar deduction is limited to the taxpayer’s state and local marginal rate, the risk of deductions being used to circumvent Code Sec. 164(b)(6) is comparatively low. (Preamble to Prop Reg REG-112176-18)
However, the proposed regs state that, if the taxpayer receives or expects to receive a state or local tax deduction that exceeds the amount of the taxpayer’s payment or the fair market value of the property transferred, the taxpayer’s charitable contribution deduction would have to be reduced. (Prop Reg § 1.170A-1(h)(3)(ii)(B))
Observation. The proposed reg does not spell out the amount by which the taxpayer’s charitable contribution deduction would have to be reduced.
The rule of Prop Reg § 1.170A-1(h)(3)(i) would also not apply for tax credits of no more than 15% of the cash paid, or of the fair market value of the property transferred, to the State. (Prop Reg § 1.170A-1(h)(3)(vi)) Thus, for example, a taxpayer who makes a $1,000 contribution to an eligible entity would not be required to reduce the $1,000 deduction on the taxpayer’s federal income tax return if the state or local tax credit received or expected to be received was no more than $150. (IR 2018-172)
IRS explains that this 15% de minimis rule would provide consistent treatment for state or local tax deductions and state or local tax credits that provide a benefit that is generally equivalent to a deduction. It reflects that the combined value of a state and local tax deduction, that is the combined top marginal state and local tax rate, currently does not exceed 15%. (Preamble to Prop Reg REG-112176-18)
The rules in the proposed regs are based on long-standing federal tax law principles and, thus, would apply to taxpayers that participate in new state and local tax credit programs as well as taxpayers participating in programs that were in existence before the enactment of Code Sec. 164(b)(6). (Preamble to Prop Reg REG-112176-18)
Observation: The proposed regs would effectively kill the state workarounds discussed above. That is, the function of the workarounds was to convert nondeductible state taxes into deductible charitable contributions; Prop Reg § 1.170A-1(h)(3)(i) provides that the charitable deduction provided by the workaround would be zero. And, the 15% rule in Prop Reg § 1.170A-1(h)(3)(vi) does nothing to alleviate the death of the workarounds; making a $100 contribution to a state charity in order to reduce one’s state tax liability by $15 and get a $100 federal tax deduction for the contribution is not a money-saver for any taxpayer.
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.