Under proposed regulations issued by the IRS on Thursday, transfers to a state agency or charitable organization in lieu of paying state and local taxes would be deductible as a charitable contribution only to the extent that the taxpayer making the donation did not receive a quid pro quo (REG-112176-18). Contributions that result in a state or local tax credit in return for the contribution would not be deductible for federal tax purposes to the extent of the credit; however, contributions that result in a state or local tax deduction may be deductible for federal tax purposes.
A number of states have enacted or are considering enacting programs that allow residents to make contributions to state agencies or charitable organizations in exchange for state and local tax credits. These programs are designed to allow individual taxpayers to claim charitable contribution deductions that are not subject to the new $10,000 limit on the deductibility of state and local taxes under P.L. 115-97, the law known as the Tax Cuts and Jobs Act (TCJA). In New York, for example, local governments and school districts can create charitable funds and offer donors a property tax credit. New York has also created a state charitable gifts trust fund, which permits taxpayers to make contributions for health care or education in return for a state tax credit (donors would also, presumably, attempt to take a federal charitable contribution deduction) (2018 N.Y. S.B. 7509, ch. 59). In New Jersey, taxpayers can make donations to municipal or school charitable funds and receive property tax credits (2018 N.J. S.B. 1893).
The proposed rules outline the history of the IRS’s and courts’ positions on whether a donor has received something of value in return for the charitable contribution, in which case the deduction under Sec. 170 must be reduced or eliminated. The IRS also discusses the rulings it has issued in this area permitting these deductions in certain cases (see, e.g., Chief Counsel Advice 201105010) and explains that the fact that taxpayers making these donations can now reduce their federal tax liability requires it to revisit the issue. The Service also notes that permitting the deduction would greatly reduce the amount of revenue the federal government would collect from taxpayers avoiding the $10,000 limitation.
To achieve the goals of prohibiting charitable contribution deductions when a taxpayer is receiving a benefit in return, the proposed regulations provide that if a taxpayer makes a payment or transfers property to or for the use of an entity listed in Sec. 170(c), and the taxpayer receives or expects to receive a state or local tax credit in return for that payment, then the tax credit constitutes a benefit, or quid pro quo, to the taxpayer, and the taxpayer must reduce his or her deduction for the charitable contribution by the amount of the state or local tax credit received or expected to be received.
However, the proposed rules allow a charitable contribution deduction if the state program allows dollar-for-dollar state or local tax deductions instead of credits. The IRS reasoned that even though deductions could also be considered quid pro quo benefits, sound policy considerations and efficient tax administration support making an exception to quid pro quo principles for 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 the $10,000 limitation is comparatively low. In addition, if state and local tax deductions for charitable contributions were treated as quid pro quo benefits, it would make it difficult for taxpayers to accurately calculate their state and local taxes and federal taxes.
The proposed rules also contain a de minimis exception from the prohibition of a deduction for state and local tax credits. Under this rule, a taxpayer may disregard a state or local tax credit if the credit does not exceed 15% of the taxpayer’s payment or 15% of the fair market value of the property the taxpayer transferred. This exception 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%.
The proposed regulations apply to taxpayers making contributions to any state tax credit program created after the TCJA as well as preexisting state tax credit programs created before the TCJA. The regulations are proposed to apply to contributions after Aug. 27, 2018.
The IRS is requesting comments on all aspects of the proposed rules within 45 days after their publication in the Federal Register (scheduled for Monday, Aug. 27) and is planning to hold a public hearing on Nov. 5 in Washington.
— Sally P. Schreiber, J.D., (Sally.Schreiber@aicpa-cima.com) is a Tax Adviser senior editor.