Editor: Susan Minasian Grais, CPA, J.D., LL.M.
In final regulations issued in August 2020, the IRS provided additional guidance regarding limitations on the deductibility of charitable contributions made in exchange for state and local tax (SALT) credits (T.D. 9907).
The final regulations adopt safe harbors under Secs. 162 and 164 that apply in specific situations where taxpayers make donations to charities in exchange for SALT credits. In addition, the final regulations update the Sec. 170 regulations to address how the quid pro quo principle applies to donors who receive benefits from a third party in exchange for charitable contributions.
The final regulations are a virtual carbon copy of the proposed regulations issued in December 2019 (REG-107431-19). Treasury and the IRS received more than 40 comments responding to the proposed regulations and did not adopt any of those comments, except for a few clarifications that have little impact on the regulations' effect.
The law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, imposed a $10,000 cap on the deduction for aggregated SALT (income tax, sales tax, real property tax, and personal property tax) paid during the year, for tax years beginning in calendar years 2018 through 2025 (SALT deduction limit). For married couples filing separately, the limit is $5,000.
Various state and local governments responded by creating programs aimed at helping taxpayers mitigate the effect of the SALT deduction limit, including SALT credit programs under which taxpayers who contribute to Sec. 170(c) entities created and promoted by state and local governments received a corresponding tax credit against their respective SALT liabilities in return.
Relevant to these programs, taxpayers can qualify for a charitable deduction under Sec. 170(a)(1) if the charitable contributions are made to a state, U.S. possession, political subdivision, or the District of Columbia, in addition to certain corporations, trusts, community chests, funds, or foundations organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes, or to foster amateur sports competition, or to prevent cruelty to children or animals.
In response to the creation of the state and local government programs, the IRS and Treasury issued several pieces of formal and informal guidance. In August 2018, new regulations (REG-112176-18) were proposed that would amend regulations under Sec. 170 to generally provide that if a taxpayer makes a payment or transfers property to or for the use of a Sec. 170(c) entity and receives or expects to receive a SALT credit in return, the taxpayer must reduce its charitable contribution deduction by the amount of the tax credit because it is considered a return benefit (the quid pro quo principle).
In June 2019, the IRS and Treasury issued final regulations (T.D. 9864) that largely retained the rules described in the 2018 proposed regulations. Concurrent with the 2019 final regulations, the IRS issued Rev. Proc. 2019-12 and Notice 2019-12, which contain safe harbors that generally allow businesses and individuals that itemize deductions to treat would-be charitable contribution deductions that are disallowed under the final regulations as ordinary and necessary business expenses or, in certain circumstances, as state or local taxes for federal income tax purposes.
In December 2019, the IRS issued proposed regulations that included the safe harbors provided under Rev. Proc. 2019-12 and Notice 2019-12. The proposed regulations also clarified how the quid pro quo principle applies under Sec. 170 to benefits received or expected to be received from third parties.
Confirm business expense deduction: The final regulations issued in August 2020 retain the proposed amendments to Regs. Sec. 1.162-15(a), which provide that if a taxpayer's payment or transfer has a direct relationship to its trade or business and is made with a reasonable expectation of receiving commensurate financial return, the payment or transfer to a Sec. 170(c) entity may be claimed as a business expense under Sec. 162 instead of as a charitable contribution under Sec. 170.
Safe harbor under Sec. 162 for businesses: The final regulations retain a safe harbor that allows businesses making would-be charitable contributions to Sec. 170(c) entities to claim a deduction for an ordinary and necessary business expense. Specifically, the safe harbor applies to C corporations or specified passthrough entities that make payments (of cash or cash equivalents) to Sec. 170(c) organizations and receive or expect to receive state or local tax credits in return. The safe harbors allow these business entities 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. The safe harbor for specified passthrough entities does not apply if the credit received or expected to be received reduces a state or local income tax.
Safe harbor under Sec. 164 for individuals: The final regulations retain a safe harbor for individuals who have total SALT liabilities that are below the SALT deduction limit. Specifically, the safe harbor applies if these individuals make payments (of cash or cash equivalents) to Sec. 170(c) organizations and receive or expect to receive a SALT credit in return. The individuals may treat as a payment of state or local tax for purposes of Sec. 164 the portion of such payment for which a charitable contribution deduction under Sec. 170 is disallowed under Regs. Sec. 1.170A-1(h)(3). The safe harbor may be applied in the tax year in which the payment is made but only to the extent that the SALT credit is applied under applicable state or local law to offset the taxpayer's SALT liability for that tax year or the preceding tax year. An unused credit may be carried forward and treated as a SALT payment under Sec. 164.
Under the final regulations, individuals who apply the safe harbor to make deductions under Sec. 164 may not also deduct the same payments under any other Code section.
Quid pro quo clarification: The final regulations retain the amendments to the Sec. 170 regulations regarding the application of the quid pro quo principle to a donor who receives or expects to receive benefits from a third party. The final regulations clarify that the quid pro quo principle applies regardless of whether the party providing the quid pro quo is the donee or a third party.
Specifically, the final regulations define "in consideration for" and "goods and services" for purposes of applying Regs. Sec. 1.170A-1(h) as follows: "[A] taxpayer will be treated as receiving goods and services in consideration for a taxpayer's payment or transfer to an entity described in [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." The final regulations further clarify that the fair market value of goods and services includes the value of goods and services provided by parties other than the donee.
Applicable dates: The amendments to Regs. Sec. 1.162-15 apply to payments or transfers made on or after Dec. 17, 2019. However, taxpayers may choose to apply the amendments to payments or transfers made on or after Jan. 1, 2018. Regs. Sec. 1.164-3(j) applies to payments made to Sec. 170(c) entities on or after June 11, 2019. But taxpayers may choose to apply paragraph (j) to payments made after Aug. 27, 2018. The definitions provided in Regs. Sec. 1.170A-1(h)(4) apply to amounts paid or property transferred on or after Dec. 17, 2019.
The final regulations largely reduce to regulation form the existing views of Treasury and the IRS on the state tax credit systems relating to charitable contributions. Although T.D. 9907 is a tax regulation, it was largely a joint undertaking between the departments of Treasury and Education to provide clarity on the state tax credit systems that involve contributions made to support education.
Sec. 170(c) donee organizations may want to review their procedures regarding the contemporaneous written acknowledgement of charitable contributions in order to accommodate the clarification to the quid pro quo principle.
Susan Minasian Grais, CPA, J.D., LL.M., is a managing director at Ernst & Young LLP in Washington, D.C..
For additional information about these items, contact Ms. Grais at 202-327-8788 or email@example.com.
Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.