As suspected, the IRS has ended state-run charitable contribution strategies that are intended to work around the federal limit on itemized state and local tax deductions for years 2018 through 2025.
In June 2018, we discussed in "How to Mitigate the Federal SALT Deduction Limitation Under the New Law" how a few states reacted aggressively to the $10,000 cap on state and local taxes levied by the 2017 Tax Cuts and Jobs Act (TCJA) by enacting programs that allow residents to make contributions to state and local agencies or charitable funds in exchange for state and local tax (SALT) credits. Hence, a so-called “workaround” of the $10,000 cap. Last summer, the federal government threw a counterpunch. In August 2018, the IRS issued proposed regulations (REG-112176-18) to negate the states’ attempts to work around the $10,000 cap on SALT deductions.
The Final Blow
This summer, not quite a year later, the Treasury Department and the IRS issued final regulations (T.D. 9864). They remain virtually identical to the proposed regulations and “bring the hammer down” on mainly blue states, such as Connecticut, New Jersey and New York, and their attempts to circumvent the $10,000 SALT cap imposed by the TCJA. However, the final regulations, which became effective on August 12, 2019, will also shut down preexisting programs that have allowed taxpayers to benefit for years by donating to private schools, mainly in red states. Currently, there are more than 100 of these programs to choose from in more than 30 states.
According to the U.S. Treasury, the federal government could not reasonably distinguish between new schemes that would allow residents to get a tax credit at the state level and then a contribution deduction at the federal level for contributing to government-run enterprises and long-standing programs in which states give credit for donations to charities or private schools. States may still issue such credits, but taxpayers who donate will not be allowed to deduct the amount paid from their federal returns, according to the final regulations.
For example, before the temporary regulations were issued in August 2018, if a taxpayer contributed $100,000 to a charitable contribution SALT workaround program, he or she would have received up to a $100,000 credit against state income tax and the contribution would be fully offset by the credits claimed on the state return. Additionally, if a federal tax deduction of $100,000 for a charitable contribution was claimed as an itemized deduction on the federal return, the taxpayer would have profited. The profit would reflect the federal tax savings on the $100,000 deduction. At the top federal marginal rate of 37 percent, the federal tax savings would have amounted to $37,000, in addition to the $100,000 state credit, for a total combined federal and state benefit of $137,000.
The final regulations eliminate the use of existing state tax credits as a tax arbitrage strategy; however, it would still be attractive to taxpayers who wish to contribute to causes they care about, while continuing to enjoy a greater tax benefit than taxpayers making charitable contributions outside of a state tax credit program.
In contrast, under the new regulations, assume a taxpayer contributes $100,000 to a preexisting scholarship program and resides in a state that allows the taxpayer to receive an 80 percent state tax credit. The state tax liability is reduced by $80,000, and the taxpayer can deduct the residual $20,000 as a charitable contribution on the federal return. At the top federal marginal rate of 37 percent, the federal tax savings would amount to $7,400.
In other words, a taxpayer may still direct $100,000 to a cause at a personal cost of $12,600 ($20,000-$7,400). What a taxpayer cannot do is make a profit from the contribution by receiving $80,000 back from the state while also claiming the full $100,000 contribution as a federal charitable deduction.
The final regulations also state the rules “are based on longstanding federal tax law principles, which apply equally to taxpayers regardless of whether they are participating in a new state and local tax credit program or a preexisting one.” Taxpayer benefits from donations to private school programs are considered collateral damage to the federal government’s priority to crackdown on recent enacted and proposed SALT workarounds.
De Minimis Exception
The final regulations retain the de minimis exception contained in the proposed regulations, whereby a SALT credit that doesn’t exceed 15 percent of the amount of the contribution isn’t treated as a quid pro quo benefit and therefore doesn’t reduce the federal charitable income tax deduction. The final regulations clarify, however, that the 15 percent exception applies only if the sum of the taxpayer’s SALT credits received, or expected to be received, does not exceed 15 percent of the taxpayer’s contribution. Also, similar to the proposed regulations, the final regulations apply to payments made by a trust or a decedent’s estate in determining its charitable contribution deduction under Internal Revenue Code (IRC) Section 642(c).
For example, consider a taxpayer who contributes $100,000 to a charitable contribution SALT workaround program. In exchange for the contribution, the state allows the taxpayer to receive a 15 percent state tax credit on his or her state tax return. The taxpayer is not required to apply the general rule since the state tax credit will not exceed 15 percent of the contribution. Accordingly, the amount of the taxpayer’s federal deduction for the contribution is not reduced, resulting in similar treatment to the earlier example that was in place before the temporary regulations were issued in August 2018―essentially, no change from prior law.
Under the de minimis exception, the state tax liability is reduced by $15,000 and the taxpayer can deduct the full amount, or $100,000, as a charitable contribution on the federal return. At the top federal marginal rate of 37 percent, the federal tax savings would amount to $37,000. When combined with the state credit of $15,000, the taxpayer would realize total savings of $52,000 on the $100,000 contribution. However, the taxpayer would still owe $85,000 in state tax,
Now consider a situation that falls outside of the de minimis exception. If the state tax credit rate was 16 percent, the taxpayer would be allowed state credits of $16,000, while only deducting $84,000 of charitable contributions on their federal return. At the top federal marginal rate of 37 percent, the federal tax savings would be $31,080. In this example, the taxpayer would realize a total tax savings at the federal and state levels of $47,080, thus suffering a $4,920 “penalty” by participating in the 16 percent credit program versus the 15 percent program. Additionally, the taxpayer would still owe 84,000 in state tax.
The issuance of the final regulations also followed IRS Notice 2018-54. This notice, released on May 23, 2018, was essentially a warning to taxpayers that choosing this aggressive approach may ultimately result in disallowance of charitable deductions claimed at the federal level under the quid pro quo disallowance rule of IRC Section 170.
In addition, neither the regulations nor the IRS notice address the issue of other workarounds, e.g. a pass-through entity tax (Connecticut) or additional payroll tax (New York). Prior statements from IRS officials indicate that these workarounds are in jeopardy of being prohibited also.
Along with the final regulations, the Treasury Department and IRS issued guidance (Notice 2019-12) proposing a safe harbor for taxpayers who are under the $10,000 SALT limit and would have federal charitable contribution deductions limited due to the receipt of state tax credits.
Under the safe harbor, for federal deduction purposes, such individuals may elect to treat the portion of their payment to the charitable organization that would be disallowed under the final rules as a payment of state tax, up to the $10,000 SALT deduction limit. This ensures that taxpayers below the SALT cap are not adversely affected in comparison with prior law.
The IRS intends to issue proposed regulations containing this safe harbor; however, taxpayers may rely on the notice before the regulations are issued.
The IRS’ decision not to create a discrepancy by disallowing new programs promulgated by blue states such as New York, New Jersey and California, while continuing to allow scholarship programs, mostly available in red states, has sparked controversy. Donors will no longer reap the benefits they had once enjoyed, which may add to further litigation.
In July 2018, four states (Connecticut, Maryland, New Jersey and New York) filed suit against the federal government to challenge the constitutionality of the SALT cap. On June 18, 2019, oral arguments were held on the U.S. government’s pending motion to dismiss the lawsuit and the states’ cross-motion for summary judgement in the case. The states have argued that the capped deduction would lead to increased taxes on their residents, decreased home values and revenue-raising challenges.
In addition, state and local governments have filed suit to overturn the IRS’s final regulations blocking the charitable contribution workarounds. In their July 17, 2019, complaint filed in the U.S. District Court for the Southern District of New York, the states of New Jersey, New York and Connecticut argued that the IRS regulations violate the Administrative Procedure Act (APA) and the Regulatory Flexibility Act and thus should be declared unlawful and vacated.
As suspected, the IRS has ended state-run charitable contribution strategies that are intended to work around the federal limit on itemized state and local tax deductions for years 2018 through 2025. High-tax states such as Connecticut, New York and New Jersey oppose the final regulations and will continue to fight the SALT cap through litigation. These final regulations are inconsistent with long established federal tax law that allow states to provide tax incentives for charitable donations do not affect the federal deductibility of those gifts. The IRS, despite the final regulations, has not yet concluded on how it will approach other state proposed workarounds that were not addressed in the final rules. The situation remains fluid. As the issue continues to unfold, and, as always, as major legislative developments and opportunities emerge, we are always available to discuss the impact of a new or pending tax law on your personal or business situation.
For Further Information
If you would like more information about this topic or your own unique situation, please contact Michael R. Bartosik, CPA, CFP, or any of the practitioners in the Tax Accounting Group. For information about other pertinent tax topics, please visit our publications page.
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