Proposed IRS Regs Prevent Taxpayers from Working Around SALT Limitation

(Parker Tax Publishing August 2018)

The IRS issued proposed regulations which limit certain charitable contribution deductions when an individual, a trust, or a decedent's estate receives or expects to receive a corresponding state or local tax credit. The proposed rules, which apply to contributions made after August 27, 2018, are designed to prevent taxpayers from circumventing the $10,000 limitation on the personal deduction for state and local tax (SALT) by substituting an increased charitable contribution deduction. REG-112176-18.

Background

In recent years, it has become increasingly common for states and localities to provide state or local tax credits in return for contributions by taxpayers to, or for the use of, certain entities listed in Code Sec. 170(c).

As the use of such tax credit programs by states and localities became more common, the IRS, in multiple Chief Counsel Advice (CCA) memoranda, considered whether the receipt of state tax credits under these programs were quid pro quo benefits that would affect the amount of taxpayers' charitable contribution deductions under Coder Sec. 170(a). In CCA 2000238041 and CCA 200435001, the 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. In these CCAs, the IRS Chief Counsel recognized that these programs raised complex questions and recommended that the tax credit issue be addressed through official published guidance.

In CCA 201105010, the IRS offered further advice while also explaining that published guidance would not be forthcoming. The IRS 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 Code Sec. 170 or a payment of state tax possibly deductible under Code Sec. 164. The IRS advised that a deduction under Code Sec. 170 was available 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 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 Code Sec. 164. The 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."

In Maines v. Comm'r, 144 T.C. 123 (2015), the IRS took the position that the amount of a state or local tax credit that reduces a tax liability is not an accession to wealth under Code Sec. 61 or an amount realized for purposes of Code Sec. 1001, and the Tax Court has accepted that view. The Tax Court held that the non-refundable portion of a state income tax credit, the amount of which was based on previously-paid property taxes, reduced the taxpayer's current year's tax liability and was not taxable or treated as an item of income. In Tempel v. Comm'r, 136 T.C. 341 (2011), the Tax Court held that state income tax credits, received by a donor for the transfer of a conservation easement, were capital assets; however, the donor had no adjusted basis in the credits.

The application of Code Sec. 61 and Code Sec. 1001 to state or local tax credits presents different issues than the application of Code Sec. 170. None the cases cited above addressed whether a taxpayer's expectation or receipt of a state or local tax credit may reduce a taxpayer's charitable contribution deduction under Code Sec. 170. Nor has the IRS ever addressed this question in published guidance.

Change in Law Required IRS to Act on State Credit Issue

At the time CCA 201105010 was issued, Code Sec. 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), a deduction was likely to be available under either Code Sec.164 or Code Sec. 170. Permitting a charitable contribution deduction for a transfer made in exchange for a state or local tax credit generally had no effect on a taxpayer's federal income tax liability because any increased deduction under Code Sec. 170 would be offset by a decreased deduction under Code Sec. 164.

However, effective for tax years beginning after 2017 and before 2026, the Tax Cuts and Jobs Act of 2017 (TCJA) amended Code Sec. 164 to provide a $10,000 limitation on the deductibility of state and local taxes under Code Sec. 164(b)(6). Thus, 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 (SALT) liabilities in excess of the $10,000 limitation, a charitable contribution deduction under Code Sec. 170 would no longer be offset by a reduction in the taxpayer's SALT deduction under Code Sec. 164. As a consequence, SALT credit programs now give taxpayers a potential means to circumvent the $10,000 limitation in Code Sec. 164(b)(6) by substituting an increased charitable contribution deduction for a disallowed SALT deduction.

The IRS noted that several state legislatures are also now considering, or have adopted, proposals to enact new SALT 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. In light of the tax consequences of Code Sec. 164(b)(6) and the resulting increased interest in preexisting and new state tax credit programs, the IRS determined that it was appropriate to review the question of whether amounts paid, or property transferred, in exchange for state or local tax credits should be fully deductible as charitable contributions under Code Sec. 170.

In May, the IRS issued Notice 2018-54, in which it announced its intention to propose regulations addressing the federal income tax treatment of payments made by taxpayers for which the taxpayers receive a credit against their state and local taxes. The notice stated that federal tax law controls the proper characterization of payments for federal income tax purposes and that proposed regulations would assist taxpayers in understanding the relationship between the federal charitable contribution deduction and the new limitation on the deduction for SALT payments. Although Notice 2018-54 was issued in response to state legislation proposed after the enactment of the limitation on SALT deductions under Code Sec. 164(b)(6), the IRS said it would be issuing regulations which would apply longstanding federal tax law principles equally to taxpayers regardless of whether they are participating in a new SALT credit program or a preexisting one.

On August 23, the IRS issued the proposed regulations. According to the IRS, the proposed regulations, and the analysis underlying the proposed regulations, are intended to apply to transfers pursuant to SALT credit programs established under the recent state legislation as well as to transfers pursuant to SALT credit programs that were in existence before the enactment of Code Sec. 164(b)(6).

Observation: While the impetus for the proposed regulations was the recent enactment of tax credit workarounds designed to circumvent TCJA's limitation on the SALT deduction, the rules will also affect taxpayers seeking to claim a charitable contribution deduction for other programs that provide state or local tax credits in exchange for contributions to designated funds or entities, such as educational scholarship funds. The proposed regs do not include any special rules or exceptions for such programs, many of which have been in place for years.

Proposed Regulations

General Rule. When a taxpayer receives or expects to receive a state or local tax credit in return for a payment or transfer to an entity listed in Code Sec. 170(c), the proposed regulations provide that the receipt of this tax benefit constitutes a quid pro quo that may preclude a full deduction under Code Sec. 170(a). In applying Code Sec. 170 and the quid pro quo doctrine, the IRS said it does not believe it is appropriate to categorically exempt state or local tax benefits from the normal rules that apply to other benefits received by a taxpayer in exchange for a contribution. Thus, the IRS believes that the amount otherwise deductible as a charitable contribution must generally be reduced by the amount of the state or local tax credit received or expected to be received, just as it is reduced for many other benefits. Accordingly, the IRS is amending the regulations under Code Sec. 170 to clarify this general requirement, to provide for a de minimis exception from the general rule, and to make other conforming amendments.

The proposed regulations generally provide that if a taxpayer makes a payment or transfers property to or for the use of an entity listed in Code Sec. 170(c), and the taxpayer receives or expects to receive a state or local tax credit in return for such payment, the tax credit constitutes a return benefit, or quid pro quo, to the taxpayer and reduces the charitable contribution deduction.

In addition to credits, the proposed regulations also address state or local tax deductions claimed in connection with a taxpayer's payment or transfer. Although deductions could be considered quid pro quo benefits in the same manner as credits, the IRS said it believes that sound policy considerations as well as considerations of efficient tax administration warrant making an exception to quid pro quo principles in the case of 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 Code Sec. 164(b)(6) is comparatively low. In addition, if SALT deductions for charitable contributions were treated as quid pro quo benefits, the IRS said, it would make the accurate calculation of federal taxes and state and local taxes difficult for both taxpayers and the IRS. For example, the value of a deduction could vary based on the taxpayer's marginal or effective state and local tax rates, making for more complex computations and adding to administrative and taxpayer burden. The proposed regulations thus allow taxpayers to disregard dollar-for-dollar state or local tax deductions. However, the proposed regulations state that, 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 must be reduced.

Observation: The IRS is requesting comments from practitioners on how to determine the amount of this reduction.

In drafting the proposed regulations, the IRS also considered whether a taxpayer may decline the receipt or anticipated receipt of a state or local tax credit by taking some affirmative action at the time of the taxpayer's payment or transfer. The IRS pointed to Rev. Rul. 67-246, which allows a full charitable contribution deduction if the taxpayer does not accept or keep any indicia of a return benefit.

Observation: The IRS noted that, because procedures for declining a state or local tax credit would depend on the procedures of each state and locality in administering the tax credits, it is requesting guidance from practitioners on a rule that would allow taxpayers to decline state or local tax credits and receive full deductions for charitable contributions under Code Sec. 170.

The proposed regulations also apply to trusts and decedents' estates with respect to income tax deductions they may claim for charitable contributions under Code Sec. 642(c).

De Minimis Rule. The proposed regulations also include a de minimis rule. Under this rule, a taxpayer may disregard a state or local tax credit if such credit 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. The de minimis exception reflects that the combined value of a SALT deduction, that is the combined top marginal state and local tax rate, currently does not exceed 15 percent. Accordingly, under the proposed regulations, a state or local tax credit that does not exceed 15 percent does not reduce the taxpayer's federal deduction for a charitable contribution.

Qualitative Analysis. The proposed regulations provide a qualitative analysis section which provides details regarding the anticipated impact of the proposed regulations. For informational and analytical purposes, this analysis assumes as a baseline that SALT credits are generally not treated as a return benefit or consideration and therefore do not reduce a taxpayer's charitable contribution deduction under Code Sec. 170(a). The qualitative analysis then:

(1) describes the tax effects of the contributions prior to enactment of the SALT cap;

(2) provides examples comparing the enactment of the SALT cap but absent the proposed rule (the baseline) to the proposed rule; and

(3) provides a qualitative assessment of the potential costs and benefits of the proposed rule compared to the baseline.

Example: Assume that John, who has a state tax liability of more than $1,000 above the SALT cap and is not subject to the AMT, makes a $1,000 contribution to Charity A and receives a $1,000 state tax credit. The state has a 5 percent state tax rate. As a result, the deduction for charitable contributions increases by $1,000, but the deduction for state and local taxes paid is unchanged. Consequently, itemized deductions increase by $1,000, and taxable income decreases by $1,000. If John is in the 24 percent bracket, his federal liability will decrease by $240, and his state tax liability will decrease by the $1,000 state tax credit. The combined federal and state tax benefits of the $1,000 contribution are therefore $1,240, and John receives a $240 net benefit while the federal government has a loss of $240. Under the proposed regulations, John's entire $1,000 contribution is not deductible and his deduction for state and local taxes is unchanged due to the SALT cap. John's itemized deductions, taxable income, and federal tax liability are unchanged from what they would be in the absence of the contribution. John's state tax liability decreases by $1,000 because of the state tax credit. The combined federal and state tax benefits of the $1,000 contribution are therefore $1,000, or $240 less than under the baseline.

According to the qualitative analysis provided in the preamble to the proposed regulations, prior to enactment of the SALT caps, for a taxpayer not subject to the AMT, a $1,000 contribution to a charity (Charity B), in which the contribution results in a one-for-one state income tax deduction and not a state credit, yielded a smaller combined federal and state tax benefit than to Charity A. The state tax benefit was $50 ($1,000 times the 5 percent state tax rate). The taxpayer's itemized deductions at the federal level increased by $950 (the $1,000 charitable contribution deduction less than $50 reduction in state taxes paid). The federal tax benefit of this increase was $228 ($950 times the 24 percent federal tax rate), resulting in a combined federal and state tax benefit of $278. The net cost to the taxpayer of the $1,000 contribution was $722.

The qualitative analysis notes that, under the baseline and the proposed rule, for a taxpayer with state and local taxes paid over the SALT cap, the value of a contribution to Charity B, in which the contribution results in a one-for-one state income tax deduction and not a state tax credit, is slightly higher than it was before the SALT cap applied. This increase is because the state deduction does not reduce the federal deduction for state and local taxes for a taxpayer above the SALT cap. Under the baseline and the proposed rule, the value of a $1,000 contribution to Charity B is $290 - the charitable contribution deduction from federal tax ($1,000 times the 24 percent federal tax rate, or $240), plus the value of the deduction from state tax ($1,000 times the 5 percent state tax rate, or $50) - compared to $278 for contributions under prior law (described above). By comparison, in the example above, a contribution by John to Charity A, eligible for a state tax credit, yields a $1,240 tax benefit under the baseline and a $1,000 benefit under the proposed rule.

Effective Date

The regulations are proposed to apply to contributions made after August 27, 2018.

Caution: While the proposed regulations clearly apply to charitable contributions made after the effective date, they do not create a safe harbor for earlier contributions. To the contrary, the IRS's stance that the proposed regulations apply longstanding federal tax law principles suggests that the IRS may challenge the deductibility of contributions made on or before the effective date.

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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