Charitable Contributions Generally Must Be Reduced by Any Amount Received as Credit Against State or Local Taxes
The much anticipated proposed regulations to deal with the various credits that could be used to work around the newly imposed limitation found at IRC §164(b)(6) on deductions for state and local taxes have been released by the IRS (REG-112176-18). The resulting rules are going to affect both the new workaround credits passed by New York, Connecticut, New Jersey and other states following the passage of the Tax Cuts and Jobs Act, as well as already existing credits in other states.
The credits in question give taxpayers a credit for all or a very significant portion of the contribution made as a direct reduction in state income taxes or property taxes. Credits of this type had existed for years, being especially popular as credits for making contributions to organizations that provided scholarships or financial support to students attending private primary and secondary schools.
Prior Guidance and Impact of the Tax Cuts and Jobs Act
The IRS had ruled in years before the effective date of the §164(b)(6) limit on the deduction of state and local taxes, in a Chief Counsel Advice, that such contributions were deductible in full on Schedule A, with the charitable contribution not reduced by the amount of the state tax benefit. As the preamble to the proposed regulations explains:
In CCAs issued in 2002 and 2004, IRS Chief Counsel reviewed programs involving the issuance of state tax credits in return for the transfer of conservation easements and for payments to certain child care organizations. See CCA 200238041 (July 24, 2002); CCA 200435001 (July 28, 2004). In these CCAs, IRS Chief Counsel recognized that these programs raised complex questions and recommended that the tax credit issue be addressed through official published guidance.
In 2010, another CCA explained that published guidance on the issue was not contemplated at that time, but it offered further advice. See CCA 201105010 (Oct. 27, 2010) (the 2010 CCA). This 2010 CCA 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 section 170 or a payment of state tax possibly deductible under section 164. The 2010 CCA advised that taxpayers 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. The analysis in the 2010 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 section 164. The 2010 CCA cautioned, however, that “there may be unusual circumstances in which it would be appropriate to recharacterize a payment of cash or property that was, in form, a charitable contribution as, in substance, a satisfaction of tax liability.”
But before discussing those CCAs, the preamble reminds us that these items are not binding guidance:
Although CCAs are released to the public for information purposes, it should be noted that CCAs are not official rulings or positions of the IRS, are not ordinarily reviewed by the Treasury Department, and are not precedential.
As may guess, that warning is in the document because the IRS was planning to now issue formal guidance that was at odds with the conclusion of the 2010 CCA.
In the preamble the IRS does note that the passage of TCJA made a fundamental change in the tax impact of such credits—but now the situation is very different.
At the time the 2010 CCA was issued, section 164 generally allowed an itemized deduction—unlimited in amount—for the payment of state and local taxes. Accordingly, the question of how to characterize transfers pursuant to state tax credit programs had little practical consequence from a federal income tax perspective because, unless the taxpayer was subject to the alternative minimum tax (AMT) under section 55, a deduction was likely to be available under either section 164 or section 170. Permitting a charitable contribution deduction for a transfer made in exchange for a state or local tax credit generally had no effect on federal income tax liability because any increased deduction under section 170 would be offset by a decreased deduction under section 164.
However, as a result of the new limit on the deductibility of state and local taxes under section 164(b)(6) (as added by the Act), treating a transfer pursuant to a state or local tax credit program as a charitable contribution for federal income tax purposes may reduce a taxpayer’s federal income tax liability. When a charitable contribution is made in return for a state or local tax credit and the taxpayer has pre-credit state and local tax liabilities in excess of the $10,000 limitation in section 164(b)(6), a charitable contribution deduction under section 170 would no longer be offset by a reduction in the taxpayer’s state and local tax deduction under section 164. Thus, as a consequence, state and local tax credit programs now give taxpayers 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. State legislatures are also now considering or have adopted proposals to enact new state and local tax credit programs with the aim of enabling taxpayers to characterize their transfers as fully deductible charitable contributions for federal income tax purposes, while using the same transfers to satisfy or offset their state or local tax liabilities.
Due to this change in circumstance, the IRS concludes that the agency needed to review the treatment of such programs from scratch and to finally issue formal guidance in this area.
The IRS notes that although Notice 2018-54 was issued in response to the credit programs enacted by New York, New Jersey and Connecticut, the regulations apply to all such programs and not merely those enacted following TCJA.
Although Notice 2018-54 was issued in response to state legislation proposed after the enactment of the limitation on state and local tax deductions under section 164(b)(6), the rules in these proposed regulations are based on longstanding federal tax law principles, which apply equally to taxpayers regardless of whether they are participating in a new state and local tax credit program or a preexisting one. Accordingly, the proposed regulations, and the analysis underlying the proposed regulations, are intended to apply to transfers pursuant 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).
Proposed Regulations on State and Local Tax Credits
Proposed Reg. §1.170A-1(h)(3) contains the rules that will apply to those making donations that give rise to a state or local tax credit. The regulation provides that unless a 15% exception is met:
…if a taxpayer makes a payment or transfers 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(a) 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.[1]
The IRS does allow for an exception to this rule if the credit is less than 15% of the contribution—then no reduction of the donation is required. No reduction is required:
…if the amount of the state or local tax credit received or expected to be received by the taxpayer does not exceed 15 percent of the taxpayer’s payment, or 15 percent of the fair market value of the property transferred by the taxpayer.[2]
The fact that the charity the taxpayer donates the money or property to is not the state, or so does not directly provide the consideration received in exchange for the donation, is not relevant. The contribution must still be reduced by the state or local tax credit.[3]
The regulation does not require determining if a taxpayer is able to use the credit—the reduction will be the maximum amount available even if the taxpayer is not actually able to use the credit:
(iv) Amount of reduction. For purposes of paragraph (h)(3)(i) of this section, the amount of any state or local tax credit is the maximum credit allowable that corresponds to the amount of the taxpayer’s payment or transfer to the entity listed in section 170(c).[4]
The regulation notes that if a taxpayer merely receives a state or local deduction for an amount not in excess of the payment or the fair market value of the property given, no reduction is required:
If a taxpayer makes a payment or transfers property to or for the use of an entity listed in section 170(c), and the taxpayer receives or expects to receive a state or local tax deduction that does not exceed the amount of the taxpayer’s payment or the fair market value of the property transferred by the taxpayer to such entity, the taxpayer is not required to reduce its charitable contribution deduction under section 170(a) on account of such state or local tax deduction.[5]
However, the IRS did move to block the idea of crafting a workaround for these regulations that would grant a deduction that was a multiple of the amount given or fair value of the property given.
(B) Excess state or local tax deductions. 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 under section 170 is reduced.[6]
These proposed regulations will apply to income tax returns of estates and trusts as well as individuals.[7]
Effective Date
These rules are proposed to apply to amounts paid or property transferred after August 27, 2018.
Examples of Applying the Provisions of the Proposed Regulations
Proposed Reg. §1.170A-1(h)(3)(vii) contains the following three examples of applying the proposed regulation’s rules:
Example 1, Proposed Reg. §1.170A-1(h)(3)(vii)
A, an individual, makes a payment of $1,000 to X, an entity listed in section 170(c). In exchange for the payment, A receives or expects to receive a state tax credit of 70% of the amount of A’s payment to X. Under paragraph (h)(3)(i) of this section, A’s charitable contribution deduction is reduced by $700 (70% x $1,000). This reduction occurs regardless of whether A is able to claim the state tax credit in that year. Thus, A’s charitable contribution deduction for the $1,000 payment to X may not exceed $300.
Example 2, Proposed Reg. §1.170A-1(h)(3)(vii)
B, an individual, transfers a painting to Y, an entity listed in section 170(c). At the time of the transfer, the painting has a fair market value of $100,000. In exchange for the painting, B receives or expects to receive a state tax credit equal to 10% of the fair market value of the painting. Under paragraph (h)(3)(vi) of this section, B is not required to apply the general rule of paragraph (h)(3)(i) of this section because the amount of the tax credit received or expected to be received by B does not exceed 15% of the fair market value of the property transferred to Y. Accordingly, the amount of B’s charitable contribution deduction for the transfer of the painting is not reduced under paragraph (h)(3)(i) of this section.
Example 3, Proposed Reg. §1.170A-1(h)(3)(vii)
C, an individual, makes a payment of $1,000 to Z, an entity listed in section 170(c). In exchange for the payment, under state M law, C is entitled to receive a state tax deduction equal to the amount paid by C to Z. Under paragraph (h)(3)(ii)(A) of this section, C is not required to reduce its charitable contribution deduction under section 170(a) on account of the state tax deduction.
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