Proposed Regs Clarify Rules on Charitable Donations and State Tax Considerations

(Parker Tax Publishing January 2020)

The IRS issued proposed regulations which (1) update the Code Sec. 162 regulations to reflect current law regarding the application of Code Sec. 162 to a taxpayer that makes a payment or transfer to an entity described in Code Sec. 170(c) for a business purpose; (2) provide safe harbors under Code Sec. 162 with respect to the treatment of payments made by business entities to an entity described in Code Sec. 170(c); (3) provide a safe harbor under Code Sec. 164 for payments made to an entity described in Code Sec. 170(c) by individuals who itemize deductions and receive or expect to receive a state or local tax credit in return; and (4) update the regulations under Code Sec. 170 to reflect past guidance and case law regarding the application of the quid pro quo principle under Code Sec. 170 to benefits received or expected to be received by a donor from a third party. REG-107431-19.

Background

Code Sec. 170(a)(1) generally allows an itemized deduction for any charitable contribution paid within the tax year. Code Sec. 170(c) defines "charitable contribution" as a contribution or gift to or for the use of an entity described in that section. Code Sec. 164(b)(6), as added by the Tax Cuts and Jobs Act of 2017 (TCJA), provides that in the case of an individual, deductions for foreign real property taxes are not allowable under Code Sec. 164(a)(1), and the deduction for the aggregate amount of the following state and local taxes paid during the calendar year is limited to $10,000 ($5,000 in the case of a married individual filing a separate return): (1) real property taxes; (2) personal property taxes; (3) income, war profits, and excess profits taxes; and (4) general sales taxes. This limitation applies to tax years beginning after December 31, 2017, and before January 1, 2026, and does not apply to foreign taxes described in Code Sec. 164(a)(3) or to any taxes described in Code Sec. 164(a)(1) and (2) that are paid or accrued in carrying on a trade or business or an activity described in Code Sec. 212.

In response to the limitation in Code Sec. 164(b)(6), some taxpayers have discussed tax planning strategies to avoid or mitigate its effects. Some of these strategies rely on state and local tax credit programs under which states provide tax credits in return for contributions by taxpayers to entities described in Code Sec. 170(c), and some state and local governments have created new programs intended to facilitate use of these strategies.

In 2018, the IRS issued proposed regulations which generally provided that, if a taxpayer makes a payment or transfers property to or for the use of an entity described in Code Sec. 170(c), and the taxpayer receives or expects to receive a state or local tax credit in return for such payment or transfer, the tax credit constitutes a return benefit to the taxpayer and reduces the taxpayer's charitable contribution deduction. The 2018 proposed regulations were premised, in part, on the quid pro quo principle articulated by the Supreme Court in U.S. v. American Bar Endowment, 477 U.S. 105 (1986), that a payment of money generally cannot constitute a charitable deduction if the contributor expects a substantial benefit in return. The 2018 proposed regulations also proposed amending regulations under Code Sec. 642(c), to provide a similar rule for payments made by a trust or a decedent's estate. Those regulations were finalized in June 2019 in T.D. 9864. The final regulations retained the rules set out in the 2018 proposed regulations, with certain clarifying and technical changes. Most significantly, the final regulations retained the general rule that, if a taxpayer makes a payment or transfers property to or for the use of an entity described in Code Sec. 170(c), and the taxpayer receives or expects to receive a state or local tax credit in return for such transfer, the tax credit constitutes a return benefit to the taxpayer, or quid pro quo, reducing the taxpayer's charitable contribution deduction.

In response to two issues raised by commentators regarding the treatment of business entity payments to entities described in Code Sec. 170(c) and the treatment of payments by individuals with total state and local tax liabilities that are less than or equal to the Code Sec. 164(b)(6) limitations, the IRS provided sub-regulatory safe harbors in Rev. Proc. 2019-12 and Notice 2019-12, respectively. A third issue raised by commentators was the application of the quid pro quo principle under Code Sec. 170 to benefits received or expected to be received by the donor from a party other than the donee. This issue was not addressed in any sub-regulatory guidance but it was extensively addressed in the preamble to the final regulations. In that preamble, the IRS said it would propose additional regulations setting forth a general rule for benefits received or expected to be received from third parties. On February 17, in REG-107431-19, the IRS issued proposed regulations which would amend the regulations under Code Sec. 162, Code Sec. 164, and Code Sec. 170 to provide guidance on these three issues.

Payments by Business Entities in Exchange for State or Local Tax Credits

In the interest of providing certainty for taxpayers, the proposed regulations incorporate the safe harbors set out in Rev. Proc. 2019-12 and propose additional revisions to Reg. Sec. 1.162-15(a) to more clearly reflect the current state of the law regarding a taxpayer's payment or transfer to an entity described in Code Sec. 170(c). If the taxpayer's payment or transfer bears a direct relationship to its trade or business, and the payment is made with a reasonable expectation of commensurate financial return, the payment or transfer to the Code Sec. 170(c) entity may constitute an allowable deduction as a trade or business expense under Code Sec. 162, rather than a charitable contribution under Code Sec. 170.

Payments by Individuals in Exchange for State and Local Tax Credits

The IRS said that it believes that Notice 2019-12 provides a fair, reasonable, and legally sound basis for the safe harbor for individual taxpayers, and that the safe harbor should be added to the regulations under Code Sec. 164. Accordingly, the proposed regulations propose adding Reg. Sec. 1.164-3(j) to provide a safe harbor for individuals who make a payment to or for the use of an entity described in Code Sec. 170(c) in return for a state or local tax credit. Under the proposed regulations, an individual who itemizes deductions and who makes a payment to a Code Sec. 170(c) entity in exchange for a state or local tax credit may treat as a payment of state or local tax for purposes of Code Sec. 164 the portion of such payment for which a charitable contribution deduction under Code Sec. 170 is or will be disallowed under Reg. Sec. 1.170A-1(h)(3). This treatment is allowed in the tax year in which the payment is made, but only to the extent that the resulting credit is applied pursuant to applicable state or local law to offset the individual's state or local tax liability for such tax year or the preceding tax year. Any unused credit permitted to be carried forward may be treated as a payment of state or local tax under Code Sec. 164 in the tax year or years for which the carryover credit is applied in accordance with state or local law. The safe harbor for individuals applies only to payments of cash and cash equivalents.

The proposed regulations are not intended to permit a taxpayer to avoid the limitations of Code Sec. 164(b)(6). Therefore, the proposed regulations provide that any payment treated as a state or local tax under Code Sec. 164, pursuant to the safe harbor provided in Prop. Reg. Sec. 1.164-3(j), is subject to the limitations on deductions in Code Sec. 164(b)(6). Furthermore, the IRS noted, the proposed regulations are not intended to permit deductions of the same payments under more than one provision. Thus, the proposed regulations provide that an individual who relies on the safe harbor in Reg. Sec. 1.164-3(j) to deduct qualifying payments under Code Sec. 164 may not also deduct the same payments under any other section of the Code.

Consideration Provided by Party Other Than the Donee

In the preamble to the final regulations, the IRS acknowledged that the final regulations did not address all situations in which a taxpayer makes a payment or transfers property and receives or expects to receive benefits from a party that is not the donee. The IRS indicated its intent to propose amendments to the regulations under Code Sec. 170 to make clear that the quid pro quo principle applies regardless of whether the party providing the quid pro quo is the donee.

In the proposed regulations preamble, the IRS states that the quid pro quo principle is equally applicable regardless of whether the donor expects to receive the benefit from the donee or from a third party. In either case, the donor's payment is not a charitable contribution or gift to the extent that the donor expects a substantial benefit in return. Accordingly, the IRS is proposing amendments to Reg. Sec. 1.170A-1(h) that address a donor's payments in exchange for consideration in order for the regulation to reflect existing law. Specifically, the proposed amendments revise Reg. Sec. 1.170A-1(h)(4) to provide definitions of "in consideration for" and "goods and services" for purposes of applying the rules in Reg. Sec. 1.170A-1(h). Under the proposed regulations, a taxpayer will be treated as receiving goods and services in consideration for a taxpayer's payment or transfer to an entity described in Code Sec. 170(c) if, at the time the taxpayer makes the payment or transfer, the taxpayer receives or expects to receive goods or services in return. For additional clarity, the proposed regulations amend the language in Reg. Sec. 1.170A-1(h)(2)(i)(B) to clarify that the fair market value of goods and services includes the value of goods and services provided by parties other than the donee. Also, the proposed regulations add a definition of "goods and services" that is the same as the definition in Reg. Sec. 1.170A-13(f)(5).

For a discussion of the limitation on charitable contribution deductions that involve a quid pro quo with respect to state taxes, see Parker Tax ¶83,150.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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