IRS Finalizes Regs Limiting Contributions in Exchange for State Tax Credits

(Parker Tax Publishing June 2019)

The IRS issued final regulations under Code Sec. 170 governing the availability of charitable contribution deductions when a taxpayer receives or expects to receive a corresponding state or local tax credit. The final regulations also apply similar rules to payments made by a trust or a decedent's estate. T.D. 9864.

Background

Under Code Sec. 164, taxpayers are generally entitled to take an itemized deduction for the payment of certain taxes, including state and local, and foreign, real property taxes; state and local personal property taxes; and state and local, and foreign, income, war profits, and excess profits taxes. The Tax Cuts and Jobs Act of 2017 (TCJA) added Code Sec. 164(b)(6), effective for tax years 2018 through 2025, which limits an individual's deduction for the aggregate amount of state and local taxes paid during the calendar year to $10,000 ($5,000 in the case of a married individual filing a separate return). This limitation 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 and incurred in carrying on a trade or business or an activity described in Code Sec. 212.

In response to this new limitation, some taxpayers began pursuing tax planning strategies with the goal of avoiding or mitigating the limitation. These strategies generally rely on state and local tax credit programs under which states provide tax credits in return for contributions by taxpayers to or for the use of certain entities described in Code Sec. 170(c). The use of state or local tax credits to incentivize charitable giving is not new - in fact, it has become increasingly common over the past 20 years. Moreover, since the enactment of the limitation under Code Sec. 164(b)(6), some states and local governments have created additional programs intended to work around the new limitation on the deduction of state and local taxes.

As a result of the new limitation, and the subsequent efforts by states and taxpayers to devise alternate means for deducting the disallowed portion of their state and local taxes, questions have arisen as to whether a state or local tax credit should be treated as a return benefit - a quid pro quo - when received in return for making a payment or transfer to a tax-exempt entity described in Code Sec. 170(c). Before the enactment of the limitation under Code Sec. 164(b)(6), there was no published guidance on this issue. In 2010, however, the IRS Chief Counsel advised in CCA 201105010 that, under certain circumstances, a taxpayer may take a deduction under Code Sec. 170 for the full amount of a contribution made in exchange for a state tax credit, without subtracting the value of the credit received in return. The IRS Chief Counsel's Office has also taken the position in Tax Court litigation that the amount of a state or local tax credit that reduces a tax liability is not an accession to wealth includible in income under Code Sec. 61 or an amount realized for purposes of Code Sec. 1001. In Maines v. Comm'r, 144 T.C. 123 (2015), Tempel v. Comm'r, 136 T.C. 341 (2011), and other cases, the Tax Court agreed with the Chief Counsel's position.

Upon reviewing the authorities under Code Sec. 170, the IRS questioned the reasoning of the CCA 201105010 and, on June 11, 2018, issued Notice 2018-54, announcing its intention to propose regulations addressing the federal income tax treatment of contributions pursuant to state and local tax credit programs. Those proposed regulations were issued in August of 2018 and generally state 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 taxpayer's charitable contribution deduction. The proposed regulations include a separate rule for state and local tax deductions, which provides that such deductions do not constitute a quid pro quo unless they exceed the amount of the donor's payment or transfer. The proposed regulations also include an exception under which a state or local tax credit is not treated as a quid pro quo if the 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. Finally, the proposed regulations would provide similar rules for payments made for a purpose specified in Code Sec. 170(c) by a trust or decedent's estate.

Observation: The IRS said that it received more than 7,700 comments on the proposed regulations.

Following the public hearing on the proposed regulations, the IRS issued Rev. Proc. 2019-12 to address concerns raised about the proposed regulations. Rev. Proc. 2019-12 provides a safe harbor under Code Sec. 162 for certain payments made by a C corporation or specified passthrough entity to or for the use of an organization described in Code Sec. 170(c) if the C corporation or specified passthrough entity receives or expects to receive a state or local tax credit in return for such payment. Subsequently, the IRS also issued Notice 2019-12, which provides a safe harbor for payments made by certain individuals. Under the safe harbor, an individual who itemizes deductions and makes a payment to a Code Sec. 170(c) entity in return for a state or local tax credit may treat the portion of such payment that is, or will be, disallowed as a charitable contribution deduction under Code Sec. 170 as a payment of state or local tax for purposes of Code Sec. 164. This disallowed portion of the payment may be treated as a payment of state or local tax under Code Sec. 164 when and to the extent an individual applies the state or local tax credit to offset the individual's state or local tax liability. In Notice 2019-12, the IRS requested comments from practitioners for purposes of incorporating the safe harbor in that notice into anticipated proposed regulations under Code Sec. 164.

On June 11, in T.D. 9864, the IRS finalized the proposed regulations under Code Sec. 170. The final regulations apply to amounts paid or property transferred by a taxpayer after August 27, 2018.

Final Regulations Generally Retain Changes Set Forth in the Proposed Regulations

The final regulations generally retain the proposed amendments set forth in the proposed regulations, with certain clarifying and technical changes. First, the final regulations retain 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 payment, the tax credit constitutes a return benefit to the taxpayer, or quid pro quo, reducing the taxpayer's charitable contribution deduction.

Second, the IRS has concluded that state tax credits and state tax deductions should be treated differently in light of policy and tax administration considerations identified in the preamble of the proposed regulations. Accordingly, the final regulations retain the rule that a taxpayer generally is not required to reduce its charitable contribution deduction on account of its receipt of state or local tax deductions. However, the final regulations also retain the exception to this rule for excess state or local tax deductions. Specifically, the taxpayer must reduce its charitable contribution deduction if it receives or expects to receive state or local tax deductions in excess of the taxpayer's payment or the fair market value of property transferred by the taxpayer.

Third, the final regulations retain the 15-percent exception, under which a taxpayer may disregard state and local tax credits as a return benefit where such credits do not exceed 15 percent of the taxpayer's payment. However, the final regulations clarify that this 15-percent exception applies only if the sum of the taxpayer's state and local tax credits received, or expected to be received, 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.

Fourth, the final regulations reflect the correction of a typographical error in Reg. Sec. 1.170A-1(h)(3)(i) and clarify the terms used to describe entities that may receive charitable contributions under Code Sec. 170(c). Specifically, the final regulations refer to entities "described" in Code Sec. 170(c), rather than entities "listed" under Code Sec. 170(c).

Finally, the final regulations include the proposed amendments to Reg. Sec. 1.642(c)-3 providing that the final rules under Reg. Sec. 1.170A-1(h)(3) apply to payments made by a trust or decedent's estate in determining its charitable contribution deduction under Code Sec. 642(c).

IRS Admits Departure from Prior Guidance

In the preamble to the final regulations, the IRS acknowledged that the proposed and final regulations depart from the conclusion of CCA 201105010 in important respects. For example, while CCA 201105010 concluded that a taxpayer may take a deduction under Code Sec. 170 for the full amount of a contribution made in exchange for a state tax credit, without subtracting the value of the credit received in return, it failed to persuasively explain why state and local tax credits should not count as return benefits for purposes of applying the quid pro quo principle. The IRS noted that CCA 201105010 cited cases in which courts had found that a donor's subjective motivation to minimize taxes is not a basis for disallowing a charitable deduction, but such cases did not specifically address whether the value of state or local tax credits should be treated as a quid pro quo that reduces the amount of the deduction.

The IRS observed that CCA 201105010 also cited Browning v. Comm'r, 109 T.C. 303 (1997), in which the value of a tax deduction was not treated as income under Code Sec. 61. But, the IRS said, that case did not address the application of the quid pro quo principle under Code Sec. 170 and 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. According to the IRS, with the enactment of Code Sec. 164(b)(6), that assumption no longer holds true for the vast majority of taxpayers. The changes in the tax laws reduce the number of taxpayers who will itemize deductions, and for taxpayers who itemize and have state and local tax liabilities above the new limitation, the use of the tax credit would not reduce the deduction for state and local taxes.

IRS Addresses Impact of Previous Tax Court Decisions

Also, in the preamble to the final regulations, the IRS addressed practitioners' comments that the Tax Court decisions in Maines and Tempel mean that the receipt of a state or local tax credit is, for federal tax purposes, a reduction or potential reduction in the taxpayer's state or local tax liability and not a payment includible in the taxpayer's gross income. According to the IRS, the analysis for determining whether an item is included in gross income is separate and distinct from the analysis for determining whether a payment or transfer is a deductible contribution under Code Sec. 170. Code Sec. 61(a), the IRS said, provides that gross income means all income from whatever source derived unless otherwise provided. In contrast, to be deductible as a charitable contribution under Code Sec. 170, a transfer to an entity described in Code Sec. 170(c) must be a contribution or gift, without the expectation or receipt of a return benefit. Neither Maines nor Tempel, the IRS observed, 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. As a result, the IRS concluded that Maines and Tempel are not relevant for purposes of interpreting Code Sec. 170.

For a discussion of the limitation on charitable contribution deductions made in exchange for state tax credits, 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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