The IRS has released a new set of proposed regulations on charitable contributions, quid pro quo issues and state tax deductions.[1]  But, most interestingly, these regulations omit any discussion of IRS actions to deal with state passthrough tax workarounds to the $10,000 limit on the deduction of most state and local taxes by individuals.

Adding Sub-Regulatory Guidance Into the Regulations

What are in the proposed regulations are provisions moving what had been sub-regulatory guidance issued by the IRS on their work dealing with attempts by states to work around the $10,000 limit by giving significant state tax credits to individuals who made payments to charitable organizations into the regulations themselves.  The states had reasoned, based on a prior chief counsel advice issued related to such programs, that the state tax credit would not reduce the charitable contribution.  Since charitable contributions are not limited to a set dollar amount for individuals, making a $10,000 contribution to charity and getting an 80% or even 100% offset against state and/or local taxes would allow the taxpayer to indirectly claim payments in excess of $10,000 for state and local taxes on Schedule A.

In June of 2019, the IRS issued final regulations generally requiring taxpayers to reduce any charitable contribution by a state tax credit given for the contribution if the credit exceeded 15% of the contribution made.[2]  However, the IRS had issued various items of sub-regulatory guidance to deal with special cases, items which the agency now proposes to incorporate into the regulations themselves.

The prior guidance included in the proposed regulations are:

• Revenue Procedure 2019-12 related to the application of such credits to payments made by business entities, including a safe harbor for situations where such credits will not be required to reduce the contribution,[3] and

• Notice 2019-12 which was issued at the same time as the final regulations, related to the situation where the taxpayer’s state and local tax deduction is less than $10,000, offering up a safe harbor where such a reduction also will either not be necessary or only be partially necessary.[4]

The proposed regulations also add provisions related to when a business is deemed to make a payment to an otherwise charitable entity for a business (rather than charitable) purpose.  These revisions are found at Proposed Reg. §1.162-15(a).  The proposed regulation provides:

A payment or transfer to or for the use of an entity described in section 170(c) that bears a direct relationship to the taxpayer's trade or business and that is made with a reasonable expectation of financial return commensurate with the amount of the payment or transfer may constitute an allowable deduction as a trade or business expense rather than a charitable contribution deduction under section 170.[5]

The IRS provides a pair of examples of such a business-related payment to a charity:

Example 1, Proposed Reg. §1.162-1(a)(2)

A, an individual, is a sole proprietor who manufactures musical instruments and sells them through a website. A makes a $1,000 payment to a local church (which is a charitable organization described in section 170(c)) for a half-page advertisement in the church's program for a concert. In the program, the church thanks its concert sponsors, including A. A's advertisement includes the URL for the website through which A sells its instruments. A reasonably expects that the advertisement will attract new customers to A's website and will help A to sell more musical instruments. A may treat the $1,000 payment as an expense of carrying on a trade or business under section 162.

Example 2, Proposed Reg. §1.162-1(A)(2)

P, a partnership, operates a chain of supermarkets, some of which are located in State N. P operates a promotional program in which it sets aside the proceeds from one percent of its sales each year, which it pays to one or more charities described in section 170(c). The funds are earmarked for use in projects that improve conditions in State N. P makes the final determination on which charities receive payments. P advertises the program. P reasonably believes the program will generate a significant degree of name recognition and goodwill in the communities where it operates and thereby increase its revenue. As part of the program, P makes a $1,000 payment to a charity described in section 170(c). P may treat the $1,000 payment as an expense of carrying on a trade or business under section 162. This result is unchanged if, under State N's tax credit program, P expects to receive a $1,000 income tax credit on account of P's payment, and under State N law, the credit can be passed through to P's partners.

Benefits Received from Parties Other Than the Charity

The proposed regulations also clarify that if a taxpayer receives a benefit for making a charitable contribution, the treatment of what is received under the quid pro quo rules is not impacted by whether the benefit is received directly from the charity or from another entity.  Proposed Reg. §1.170A-1(h)(4) simply expands the definition of in consideration for under the regulations, providing the following definition:

A taxpayer receives goods or services in consideration for a taxpayer's payment or transfer to an entity described in section 170(c) if, at the time the taxpayer makes the payment to such entity, the taxpayer receives or expects to receive goods or services from that entity or any other party in return.[6]

Passthrough Tax Silence

Five states have adopted special “passthrough” taxes that were clearly aimed to working around the $10,000 limit on deductions of taxes by an individual.  Such taxes are imposed on the passthrough entity directly and either the interest holder is given a tax credit to apply against state taxes for the amount of the payment or the income is treated as not taxable under state law.

Two states had these rules in place for 2018 (Connecticut and Wisconsin), and since then three more states have followed suit (Louisiana, Oklahoma and Rhode Island).  While the IRS has taken action against the tax credits with regulations and other guidance, the IRS has not issued any formal guidance on these workarounds.

An article published in Tax Notes Today Federal on December 16, 2019 quoted a number of tax commentators as positing that the IRS may be giving up on trying to come up with a system to reign in this form of workaround.[7] 

Specifically, the article quotes Bruce Ely of Bradley Arant Boult Cummings LLP as saying:

“It’s likely that Treasury’s failure or refusal to address the issue will only spur other states to enact these taxes next spring,” Ely said. He added that the only question is whether new entity-level state taxes will be mandatory, like Connecticut’s, or elective, like those adopted by the other four states.

“I’d certainly argue that silence means acquiescence on the part of the federal government,” Ely said. “It would be blatantly unfair for Treasury to issue yet another set of proposed regulations or some sort of other guidance, sometime next year, challenging the validity of these taxes more than two or three years after the fact. That would be unconscionable.” [8]

While it must be noted the IRS still could attempt to limit the use of these options, the longer they go without doing so, the more likely it is that the agency has decided against issuing guidance to try and shut down these programs.

The Tax Notes Today Federal article cited above notes that the IRS seemed to revise its stance during 2019 from indicating they were going to challenge these systems to backing away from that threat to attack them.  As the article notes:

Throughout the first part of 2019, federal officials continued to publicly express skepticism about the alternative SALT cap workarounds, though by this summer IRS Chief Counsel Michael Desmond said that the IRS hadn’t decided how or whether to respond to the new approaches.[9]

The problem is that it would likely be difficult for the IRS to design a regulation that would shut down the programs enacted after the passage of the Tax Cuts and Jobs Act, not negatively impact taxes that were in place prior to the law’s enactment, be clearly authorized under the law given that §164 specifically states the cap does not apply to taxes on a trade or business and not simply be a blueprint for how the laws should be modified to work.

For instance, it seems likely the IRS could succeed in ruling that if the equity holder is granted a credit against state taxes, the business would be required to reduce its tax deduction by that amount, with the credit considered additional taxes paid by the individual.  So the Connecticut tax could initially be shut down, but the fix would be simple—just have the income not be taxable to the individual on the state return and remove the credit.

Conversely, the IRS could argue an elective passthrough tax with no inclusion of income on the personal state return (the Wisconsin version) lacks economic substance since it is elective and serves just to attempt to move an item that otherwise would very possibly not be deductible to an equity holder up into the entity.  But, again, the fix is simple—borrow the Connecticut requirement that all passthroughs have to pay the tax.

While only five states are impacted at the time this article is being written in mid-December 2019, there are indications in a number of states that such a bill will be considered in upcoming legislative sessions.  It’s very likely, unless the IRS moves to shut down the practice, that a much larger number of states will have such a program in place a year from now.

Where does that leave advisers?  Advisers need to explain to clients that the IRS, while issuing threatening statements during 2018 and the beginning of 2019, has not actually issued any guidance in this area, despite having very directly taken on the tax credit schemes.  As well, it’s very possible the IRS will never announce they have decided these workarounds actually work—they rather will remain quiet on the issue, but just not actually challenge a position.

Then again, now that a major tax publication has published an article that suggests the IRS’s inaction is, by itself, a concession that the agency accepts these positions the agency may decide to issue a clarification indicating they are working on a way to shut down the workarounds.  So it’s important to keep an eye out for any IRS statements that may take place over the next few weeks.

[1] REG-107431-19, December 13, 2019, https://s3.amazonaws.com/public-inspection.federalregister.gov/2019-26969.pdf?utm_medium=email&utm_campaign=pi+subscription+mailing+list&utm_source=federalregister.gov (retrieved December 14, 2019)

[2] See Ed Zollars, CPA, “IRS Finalizes Regulations Requiring Reduction of Charitable Contribution Deduction by Related State Income Tax Credits in Excess of 15% of the Contribution,” Current Federal Tax Developments website, June 11, 2019, https://www.currentfederaltaxdevelopments.com/blog/2019/6/11/irs-finalizes-regulations-requiring-reduction-of-charitable-contribution-deduction-by-related-state-income-tax-credits-in-excess-of-15-of-the-contribution (retrieved December 14, 2019)

[3] See Ed Zollars, CPA, “IRS Issues Safe Harbor Procedure on Charitable Contribution Credits That Apply to Payments Made for a Trade or Business,” Current Federal Tax Developments website, December 28, 2018, https://www.currentfederaltaxdevelopments.com/blog/2018/12/28/irs-issues-safe-harbor-procedure-on-charitable-contribution-credits-that-apply-to-payments-made-for-a-trade-or-busienss (retrieved December 14, 2019)

[4] See Ed Zollars, CPA, “IRS Finalizes Regulations Requiring Reduction of Charitable Contribution Deduction by Related State Income Tax Credits in Excess of 15% of the Contribution,” Current Federal Tax Developments website, June 11, 2019, https://www.currentfederaltaxdevelopments.com/blog/2019/6/11/irs-finalizes-regulations-requiring-reduction-of-charitable-contribution-deduction-by-related-state-income-tax-credits-in-excess-of-15-of-the-contribution (retrieved December 14, 2019)

[5] Proposed Reg. §1.162-15-1(a)(1)

[6] Proposed Reg. §1.170A-1(h)(4)(i)

[7] Amy Hamilton, “IRS Silent on Passthrough Workarounds in SALT Cap Proposed Rule,” Tax Notes Today Federal, December 16, 2019, https://www.taxnotes.com/tax-notes-today-federal/tax-cuts-and-jobs-act/irs-silent-passthrough-workarounds-salt-cap-proposed-rule/2019/12/16/2b6b8 (retrieved December 14, 2019, subscription required)

[8] Amy Hamilton, “IRS Silent on Passthrough Workarounds in SALT Cap Proposed Rule,” Tax Notes Today Federal, December 16, 2019, https://www.taxnotes.com/tax-notes-today-federal/tax-cuts-and-jobs-act/irs-silent-passthrough-workarounds-salt-cap-proposed-rule/2019/12/16/2b6b8 (retrieved December 14, 2019, subscription required)

[9] Amy Hamilton, “IRS Silent on Passthrough Workarounds in SALT Cap Proposed Rule,” Tax Notes Today Federal, December 16, 2019, https://www.taxnotes.com/tax-notes-today-federal/tax-cuts-and-jobs-act/irs-silent-passthrough-workarounds-salt-cap-proposed-rule/2019/12/16/2b6b8 (retrieved December 14, 2019, subscription required)