On Aug. 23, 2018, the Treasury Department and the Internal Revenue Service issued proposed regulations in response to legislation recently enacted by a number of states aimed at allowing residents to avoid the $10,000 annual limitation on the deductibility of state and local tax payments under Section 164(b)(6) of the Tax Cuts and Jobs Act.
The legislation seeks to allow taxpayers to take an income tax charitable deduction for contributions to certain charitable organizations while permitting a credit against state or local income, real estate or other taxes for the contributions.
Some view this as an attempt by state and local government to recast SALT payments as charitable contributions by providing state and local tax credits up to the full amount of the contributions—providing an end around the $10,000 annual deduction limitation on SALT payments that doesn’t apply to charitable contributions. The issuance of the proposed regs follows IRS Notice 2018-54, released on May 23, 2018, essentially as a warning to taxpayers that such legislation wouldn’t accomplish its intended purpose, and taxpayers choosing this route might ultimately find themselves facing significant negative tax consequences.
The proposed regs provide that a taxpayer who makes payments or transfers property to an entity eligible to receive tax deductible contributions must reduce their charitable deduction by the amount of any state or local tax credit the taxpayer receives or expects to receive. Therefore, a tax credit received in return for the contribution is treated as a quid pro quo benefit for the contribution, reducing the amount of the charitable income tax deduction otherwise available. However, under a de minimis exception under the proposed regs, a state or local tax credit that doesn’t exceed 15 percent of the amount of the contribution isn’t treated as a quid pro quo benefit; therefore, it doesn’t reduce the taxpayer's charitable income tax deduction.
While the proposed regs target recently enacted state and local legislative efforts seeking to circumvent the new annual $10,000 SALT limitation, their application also extends to long-standing programs across the country in which state and local tax credits have been provided for donations to certain community organizations and private schools where, with the apparent blessing of the IRS, taxpayers have for years been claiming charitable contribution deductions notwithstanding the tax credits provided in return.
The Act, signed into law on Dec. 22, 2017, is the most far-reaching change to the Internal Revenue Code in over 30 years. Among other significant changes is the elimination or limitation until 2026 of most itemized deductions that had been allowed for individuals for federal income tax purposes. The Act places an annual $10,000 limit on the deductibility of SALT payments under new IRC Section 164(b)(6). This new limitation has prompted certain states and, in some cases, their political subdivisions, to adopt legislation seeking to allow their residents to avoid the new $10,000 annual deduction limitation or curb its impact by providing a credit against certain state and local taxes for contributions to certain newly created charitable organizations controlled by state and local governments that support government functions.
The IRS forewarned its intention to eliminate the strategy advanced by states and political subdivisions to avoid the SALT cap in Notice 2018-54, which provided background addressing the new SALT limitation and the legislation aimed at avoiding it:
Section 11042 of “The Tax Cuts and Jobs Act [of 2017],” Pub. L. No. 115-97, limits an individual’s deduction under Section 164 for the aggregate amount of state and local taxes paid during the calendar year to $10,000 ($5,000 in the case of a married individual filing a separate return). State and local tax payments in excess of those amounts are not deductible. This new limitation applies to taxable years beginning after Dec. 31, 2017 and before Jan. 1, 2026.
In response to this new limitation, some state legislatures are considering or have adopted legislative proposals that would allow taxpayers to make transfers to funds controlled by state or local governments, or other transferees specified by the state, in exchange for credits against the state or local taxes that the taxpayer is required to pay. The aim of these proposals is to allow taxpayers to characterize such transfers as fully deductible charitable contributions for federal income tax purposes, while using the same transfers to satisfy state or local tax liabilities.
As noted in Notice 2018-54, the IRS previously indicated that the guidance to be issued under the proposed regs would be limited only to contributions to newly created state or local controlled charities formed in response to the SALT cap, as opposed to contributions in connection with those preexisting tax credit programs across the country intended to support a variety of charities and educational organizations that are independent of any state or local government control. Notwithstanding, the proposed regs are broad in their application, providing that the amount of a charitable income tax deduction under IRC Section 170(a) for a contribution to any entity must be reduced by the amount of any state or local tax credit the taxpayer receives or expects to receive in return. The proposed regs, therefore, don’t differentiate between a contribution to a newly formed state-controlled entity and a contribution to an independent public charity, such as a community organization or private school.
It’s interesting that the preamble to the proposed regs specifically notes that in CCA 201105010 (Oct. 27, 2010), the IRS advised that with respect to programs providing state tax credits to taxpayers making charitable contributions to certain organizations, “taxpayer may take a deduction under section 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.” Although the CCA recognized the general principle that the value of a quid pro quo benefit reduces the charitable income tax deduction otherwise available, it specifically stated that “a state or local tax benefit is treated for federal tax purposes as a reduction or potential reduction in tax liability. As such, it’s reflected in a reduced deduction for the payment of state or local tax under § 164, not as consideration that might constitute a quid pro quo, for purposes of § 170.” On this basis, long-standing tax credit programs offered charitable contribution deductions without reduction for an otherwise quid pro quo benefit received in the form of a state or local tax credit. While CCA 201105010 isn’t a legally binding precedent, the IRS has never published formal guidance to the contrary and has apparently applied the conclusion reached in CCA 201105010.
The CCA cautioned, however, that “[t]here may be unusual circumstances in which it would be appropriate to re-characterize a payment of cash or property that was, in form, a charitable contribution as, in substance, a satisfaction of tax liability.” In the context of the facts of CCA 201105010, involving the typical tax credit program that’s been in existence for years throughout the country and pre-dated the tax programs created in response to the new SALT limitation, the IRS concluded that “in the instant case Taxpayers may take a § 170 deduction for the full amount of their charitable contributions … assuming the requirements of § 170 are otherwise met. Taxpayers are not entitled to a § 164 deduction for the amount of the state tax credit used to offset their State tax liability.”
Preexisting and New State Tax Credit Programs
The preamble to the proposed regs notes that the courts haven’t addressed the specific issue of whether a taxpayer’s expectation of a state or local tax credit may reduce a taxpayer’s charitable contribution deduction and that neither the Treasury Department nor the IRS has ever addressed this question in published guidance. The preamble also states that at the time CCA 201105010 was issued, Section 164 allowed an unlimited itemized deduction for the payment of state and local taxes, in contrast to the new annual $10,000 SALT limitation. With the SALT limitation now in place, the IRS emphasizes in the preamble that the newly created tax credit programs “now provide a potential means to circumvent the $10,000 limitation in section 164(b)(6) by substituting an increased charitable contribution deduction for a disallowed state and local tax deduction.”
In light of the tax consequences of new Section 164(b)(6), the IRS states that the “Treasury Department and the IRS determined that it was appropriate to review the question of whether amount paid or properly transfer in exchange for state or local tax credits are fully deductible as charitable contributions under section 170.” Although Notice 2018-54 was issued specifically in response to state legislation seeking an end-around the new $10,000 SALT limitation, the preamble states that the proposed regs are based on long-standing federal tax principles and, accordingly, “the proposed regulations, and the analysis under the propose regulations, are intended to apply to transfers to state and local tax credit programs established under the recent state legislation as well as to transfers pursuant to state and local tax credit programs that were in existence before the enactment of section 164(b)(6).” Therefore, the proposed regs fail to distinguish between new legislative schemes that would allow residents to contribute to a government-run charity and obtain a tax credit in return and those long-standing programs in which states provide tax credits for contributions to charities or educational institutions.
Effect of Proposed Regs
Based on what it describes as long-standing principles of cases and tax regulations, which are discussed in the preamble, the proposed regs are based on the belief of the Treasury Department and IRS “that when a taxpayer receives or expects to receive a state or local tax credit in return for payment or transfer to an entity listed in section 170(c), the receipt of this tax benefit constitutes a quid pro quo benefit that may preclude a full deduction under Section 170(a),” just as in the case of any other quid pro quo benefit obtained by a taxpayer in return for a charitable contribution.
In support of this approach, the preamble notes that compelling policy considerations reinforce this interpretation and application of Section 170 in the context, specifically stating that “[d]isregarding the value of all state benefits received or expected to be received for charitable contributions would precipitate significant revenue losses that would undermine and be inconsistent with the limitation on the deduction for state and local taxes adopted by Congress in section 164(b)(6).” When a state or local tax credit is provided in return for a charitable contribution is disallowed as a charitable contribution under the proposed regs under the quo pro quo rules, the amount of the credit is deductible as a SALT payment but, of course, subject to the annual $10,000 SALT cap imposed under IRC Section 164(b)(6) which may result, thereof, in no deduction at all. The proposed regs confirm that obtaining a state income tax deduction (as opposed to a credit) for a charitable contribution doesn’t affect the amount allowable for federal tax purposes.
Painting with a broad brush, Prop. Reg. 1.170A-1(h)(3)(i) provides a flat-out rule, applicable to both newly created a preexisting tax credit programs, that “if a taxpayer makes a payment or transfer property to or for the use of an entity listed in section 170(c), the amount of the taxpayer’s charitable contribution deduction under section 170(c) is reduced by the amount of any state or local tax credit that the taxpayer receives or expects to receive in consideration for the taxpayer’s payment or transfer.”
Prop. Reg. 1.170A-1(h)(3)(vi) provides a de minimis exception under which the amount of a state or local tax credit doesn’t reduce the otherwise available charitable income tax deduction when the amount of the credit doesn’t exceed 15 percent of the taxpayer’s payment or 15 percent of the fair market value of the property transferred by the taxpayer.
Finally, the proposed regs clarify that if a taxpayer makes a payment or transfers property and the taxpayer receives a state or local tax deduction, as opposed to a state or local tax credit, which doesn’t exceed the amount of the taxpayer’s payment or the FMV of the property transferred, there’s no reduction in the charitable deduction under Section 170(a) on account of such state or local deduction. The distinction between state or local credits and state or local deductions was made on the grounds that the benefit of a dollar-for-dollar deduction is limited by the applicable state and local marginal rates. As such, the risk of a state or local tax deduction being used to circumvent the new SALT cap is comparatively low.
The proposed regs, unlike a final regulation, have no force of law. Nonetheless, the proposed regs state that they are to apply to contributions made after Aug. 27, 2018.
The determination of the validity of a Treasury regulation may be a complex undertaking. A critically important decision was made in Chevron U.S.A. Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984), in which the Supreme Court essentially said that a regulation promulgated by the government agency charged with enforcing the law under which the regulation was issued would be upheld and the federal courts must defer to the agency’s interpretation if that interpretation is reasonable even if the court would have construed the law otherwise. However, over the years, the Supreme Court has limited the Chevron doctrine and has recently indicated that deference to the agency’s regulations won’t be “automatic” if the matter involves “vast economic and political significance” unless it is certain Congress intended the agency to resolve all ambiguities.
It certainly would appear that the $10,000 annual limit on SALT deductions is one of vast economic and political significance, and nothing in the Act or its legislation history suggests that Congress was intending to defer under the Chevron doctrine to the Treasury’s construction of the statute as it relates to state credits for contributions to charity. Hence, it seems likely taxpayers will challenge the validity of the proposed regs if adopted in their current form as final.