The IRS issued final regulations governing the availability of charitable contribution deductions under Sec. 170 when a taxpayer makes a contribution to a state or local agency or charitable fund and receives or expects to receive a corresponding state or local tax credit or deduction in return for the contribution (T.D. 9864). Proposed regulations were issued last August (REG-112176-18). The IRS also issued a safe harbor, permitting certain taxpayers who itemize their deductions to treat charitable deductions as state tax payments.
Several states have enacted programs that allow residents to make contributions to state or local agencies or charitable funds in exchange for state or local tax credits. These programs are designed to allow individual taxpayers to circumvent 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), by reducing a taxpayer’s deductible state and local taxes paid, while increasing the taxpayer’s deductible charitable contributions. The preamble to the regulations outlines the history of the IRS’s and courts’ positions on whether a donor has received something of value (a quid pro quo) in return for the charitable contribution, in which case the deduction under Sec. 170 must be reduced or eliminated.
The IRS received almost 8,000 comments on the proposed regulations and 25 requests to speak at the public hearing. Most of the comments were positive, urging the IRS to adopt the proposed regulations without change. One group of commenters objected to the IRS’s issuing regulations under Sec. 170 when the change in law was to Sec. 164, but the IRS disagreed. It found, after careful review of the issue, that long-standing principles under Sec. 170 should guide the tax treatment of these contributions.
Another group of commenters argued that the IRS should not apply a quid pro quo analysis but use a substance-over-form approach instead. The IRS declined to adopt that suggestion, having determined the quid pro quo principle provides a more sound, comprehensive, and administrable approach.
The 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 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 (Regs. Sec. 1.170A-1(h)(3)).
However, the final 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 final rules 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, i.e., the combined top marginal state and local tax rate, currently does not exceed 15%. The final regulations clarify that the 15% exception applies only if the sum of the taxpayer’s state and local tax credits received, or expected to be received, does not exceed 15% of the taxpayer’s payment or 15% of the fair market value of the property the taxpayer transferred.
The final regulations also include amendments to Regs. Sec. 1.642(c)-3, providing that Regs. Sec. 1.170A-1(h)(3) applies to payments made by a trust or a decedent’s estate in determining its charitable contribution deduction under Sec. 642(c).
The regulations are effective 60 days after June 13, 2019, the date they are scheduled to be published in the Federal Register, and apply to amounts paid or property transferred after Aug. 27, 2018, the date the proposed regulations were published.
At the same time as it issued the final regulations, the IRS published Notice 2019-12 in which it provided a safe harbor under Sec. 164 for certain individuals who make a payment to or for the use of an entity described in Sec. 170(c) in return for a state or local tax credit. Under the safe harbor, an individual may treat as a payment of state or local taxes for purposes of Sec. 164 the portion of a payment for which a charitable contribution deduction is or will be disallowed under Regs. Sec. 1.170A-1(h)(3). To qualify for the safe harbor, taxpayers must itemize deductions for federal tax purposes and have a total state and local tax liability for the year of less than $10,000.
The safe harbor is intended to mitigate the situation in which donors to a state tax credit program who itemize deductions on their federal tax return and who have a state tax liability of less than $10,000 would be precluded from taking a charitable contribution deduction for payments to Sec. 170(c) organizations to the extent they receive a state or local tax credit.
Treatment as a payment of state or local tax under Sec. 164 is allowed in the tax year in which the payment is made to the extent the resulting credit is applied, consistent with applicable state or local law, to offset the individual’s state or local tax liability for that tax year or the preceding tax year. In states and localities that permit an individual to carry forward an excess credit amount to a later tax year, an individual may treat the carryforward amount as a state or local tax payment under Sec. 164 for the tax year or years to which the credit is applied, consistent with state or local law, to offset a state or local tax liability.
The IRS intends to issue proposed regulations containing this safe harbor, but taxpayers may rely on the notice before the regulations are issued.
— Sally P. Schreiber, J.D., (Sally.Schreiber@aicpa-cima.com) is a JofA senior editor.