The IRS has issued final regulations under §170 to deal with state tax credits that reduce state income taxes in exchange for certain charitable contributions (TD 9864).[1]  While the IRS received a number of comments on the regulations, the final regulations generally adopt without change the proposed regulations issued in the summer of 2018.

Under these regulations, a taxpayer who makes a contribution to a charity for which he/she receives a tax credit against state income taxes in excess of 15% of the amount contributed must reduce the amount of the charitable contribution claimed by the amount of the credit.[2]  The amount of the reduction is the maximum amount of the credit allowable for the amount of the contribution made by the taxpayer.[3]

Example from Regulations

(A) Example 1. A, an individual, makes a payment of $1,000 to X, an entity described in section 170(c). In exchange for the payment, A receives or expects to receive a state tax credit of 70 percent 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 (0.70 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.

(B) Example 2. B, an individual, transfers a painting to Y, an entity described 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 percent 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 percent 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.[4]

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A taxpayer receiving only a deduction against taxable income for state income tax purposes is not required to reduce his/her charitable contribution deduction unless that deduction is an excess state or local tax deduction.[5] An excess state or local deduction is a deduction given to the taxpayer by the state that exceeds the taxpayer’s payment or the fair market value of the property.[6] 

Example From Regulations

(C) Example 3. C, an individual, makes a payment of $1,000 to Z, an entity described 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’s charitable contribution deduction under section 170(a) is not required to be reduced on account of C’s state tax deduction for C’s payment to Z.

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The reduction rules also apply to charitable contribution deductions under IRC §642(c) for an estate or trust.[7]

The IRS did take note of comments received that the proposed regulations’ requirement to reduce the charitable contributions did have a negative impact on taxpayers who itemized deductions and did not have state and local tax deductions in excess of $10,000.  These taxpayers would face a higher tax than that would otherwise face if they made a tax credit contribution that reduced their state and local tax deduction and for which they received no corresponding charitable contribution.

Example

LeAnn, before making a contribution to a school tuition organization for which the state will offer a 100% state tax credit on contributions up to $1,000, expects to have total state and local deductions on her 2019 Schedule A of $8,000, which includes estimated state income tax payments equal to her expected liability.  LeAnn itemizes her deductions for 2019.

Assume LeAnn, deciding to make that contribution, reduces her state tax estimated tax payment by the $1,000 credit she now expects to receive due to making a $1,000 contribution.  LeAnn’s itemized deductions and taxable income will increased by $1,000 as she loses the $1,000 state income tax deduction she would have received on the estimated tax payment but does not receive a corresponding income tax deduction once Reg. §1.170A-1(h)(3)’s rules are applied to her contribution.

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The IRS responded to this concern by issuing Notice 2019-12[8] at the same time as the final regulations. The notice provides that the IRS plans to issue proposed regulations under §164 (the deduction for state and local taxes) to amend Reg. §1.164-3 to allow certain taxpayers to elect to treat the quid pro quo payment received for the charitable contribution as a payment of state and local taxes.[9]

Under this safe harbor, an individual who itemizes deductions and who makes a payment to a section 170(c) entity in return for a state or local tax credit may treat as a payment of state or local tax for purposes of section 164 the portion of such payment for which a charitable contribution deduction under section 170 is or will be disallowed under final regulations. This treatment as a payment of state or local tax under section 164 is allowed in the taxable 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 such taxable year or the preceding taxable year. To the extent the resulting credit is not applied to offset the individual’s state or local tax liability for the taxable year of the payment or the preceding taxable year, any excess credit permitted to be carried forward may be treated as a payment of state or local tax under section 164 in the taxable year or years for which the carryover credit is applied, consistent with applicable state or local law, to offset the individual’s state or local tax liability. This safe harbor shall not apply to a transfer of property.[10]

The notice provides that the safe harbor found in the notice does not permit the taxpayer to claim the deduction under more than one Code section, nor can it be used to allow a taxpayer to avoid the $10,000 state and local tax deduction limitation found in IRC §164(b)(6).[11]

The notice provides the following examples of applying the safe harbor.

Examples from Notice 2019-12

Example 1. In year 1, Taxpayer A makes a payment of $500 to an entity described in section 170(c). In return for the payment, A receives a dollar-for-dollar state income tax credit. Prior to application of the credit, A’s state income tax liability for year 1 was $500 or more; A applies the $500 credit to A’s year 1 state income tax liability. Under section 3 of this notice, A treats the $500 payment as a payment of state income tax in year 1 for purposes of section 164. To determine A’s deduction amount, A must apply the provisions of section 164 applicable to payments of state and local taxes, including the limitation under section 164(b)(6).

Example 2. In year 1, Taxpayer B makes a payment of $7,000 to an entity described in section 170(c). In return for the payment, B receives a dollar-for-dollar state income tax credit, which under state law may be carried forward for three taxable years. Prior to application of the credit, B’s state income tax liability for year 1 was $5,000; B applies $5,000 of the $7,000 credit to B’s year 1 state income tax liability. Under section 3 of this notice, B treats $5,000 of the $7,000 payment as a payment of state income tax in year 1 for purposes of section 164. Prior to application of the remaining credit, B’s state income tax liability for year 2 exceeds $2,000; B applies the excess credit of $2,000 to B’s year 2 state income tax liability. For year 2, B treats the $2,000 as a payment of state income tax for purposes of section 164. To determine B’s deduction amounts in years 1 and 2, B must apply the provisions of section 164 applicable to payments of state and local taxes, including the limitation under section 164(b)(6)

Example 3. In year 1, Taxpayer C makes a payment of $7,000 to an entity described in section 170(c). In return for the payment, C receives a local real property tax credit equal to 25 percent of the amount of this payment ($1,750). Prior to application of the credit, C’s local real property tax liability in year 1 was $3,500; C applies the $1,750 credit to C’s year 1 local real property tax liability. Under section 3 of this notice, for year 1, C treats $1,750 as a payment of local real property tax for purposes of section 164. To determine C’s deduction amount, C must apply the provisions of section 164 applicable to payments of state and local taxes, including the limitation under section 164(b)(6).

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The safe harbor applies to payments made for such charitable contributions after August 27, 2018.[12]  Note that some taxpayer who followed the proposed regulations in preparing their 2018 income tax returns may wish to amend their returns to take advantage of the safe harbor for any post-August 27, 2018 contributions.

The IRS rejected most other recommendations received in comments, including requests to exempt programs that were in effect prior to the enactment of the Tax Cuts and Job Act’s new limitation on state and local tax deductions from the reduction.  The IRS gave the following reason for rejecting the request:

The regulations are based on longstanding federal tax law principles that apply equally to all taxpayers. To ensure fair and consistent treatment, the final regulations do not distinguish between taxpayers who make transfers to state and local tax credit programs enacted after the Act and those who make transfers to tax credit programs existing prior to the enactment of the Act. Neither the intent of the section 170(c) organization, nor the date of enactment of a particular state tax credit program, are relevant to the application of the quid pro quo principle. Accordingly, the final regulations apply the rules equally to all state and local tax credit programs, and the final regulations do not adopt commenter recommendations to create exceptions to the general rule for various types of state tax credit programs.[13]

The regulations are scheduled to take effect 60 days after they are published in the Federal Register.[14]  That day 60 days after the expected date of publication is August 12, 2019,[15] though since the regulations apply to contributions made after August 27, 2018 it’s not clear the August 12 date will have any significant impact.

[1] TD 9864, https://s3.amazonaws.com/public-inspection.federalregister.gov/2019-12418.pdf, retrieved on June 11, 2019

[2] Reg. §1.170A-1(h)(3)(i) and (vi)

[3] Reg. §1.170A-1(h)(3)(iv)

[4] Reg. §1.170A-1(h)(3)(vii)(A) and (B0

[5] Reg. §1.170A-1(h)(3)(ii)(A)

[6] Reg. §1.170A-1(h)(3)(ii)(B)

[7] Reg. §1.642(c)-3(g)

[8] Notice 2019-12, https://www.irs.gov/pub/irs-drop/n-19-12.pdf, retrieved on June 11, 2019

[9] Ibid, p. 6

[10] Ibid

[11] Ibid, pp. 6-7

[12] Ibid, p. 8

[13] TD 9864, https://s3.amazonaws.com/public-inspection.federalregister.gov/2019-12418.pdf, retrieved on June 11, 2019, pp. 39-40

[14] Ibid., p. 1

[15] IR-2019-109, “Final Regulations on Charitable Contributions and State and Local Tax Credits,” June 11, 2019