IRS moves to counteract state laws aimed to circumvent limits on state tax deductions

The IRS proposed regulations on Aug. 23 that would reduce a taxpayer’s charitable deduction by the amount of state tax and local credits received in return.

The rules attack state laws designed to circumvent limits on federal deductions for state and local tax. The Tax Cuts and Jobs Act (TCJA) generally caps the itemized deduction for state and local taxes at $10,000. Because charitable deductions are not capped, several states passed laws that set up charitable funds for state services to which taxpayers can contribute in exchange for state tax credits. The purpose is to allow taxpayers to replace a state tax payment with a charitable contribution and convert a state tax deduction into a charitable deduction.

The proposed regulations provide that charitable deductions must be reduced by any state tax credits received in exchange for making the contribution, as long as the state tax credits exceed 15% of the value of the charitable contribution. The loss of the federal deduction would remove the benefit for taxpayers to use these charitable gifts to “pay” state tax. The proposed regulations do allow a full charitable deduction for contributions that simply allow taxpayers to deduct the contribution against state and local income on a dollar-for-dollar basis. Importantly, the rules do not explicitly distinguish between the new state laws enacted in response to the TCJA and the pre-existing charitable programs in many states, although many pre-existing programs will benefit from the 15% de minimis threshold.

Grant Thornton Insight: The proposed regulations should come as no surprise. The IRS signaled its intent to shut down these state efforts in Notice 2018-54. However, the notice said the IRS was considering a form over substance approach ostensibly to recharacterize certain charitable contributions as state tax payments. Instead, the regulations use the general charitable deduction rules that reduce a deduction by the amount of any consideration received in return. The regulations are only in proposed form at this point, but the IRS could move quickly to finalize them after the comment period. They are proposed to be effective only for contributions made after Aug. 27, 2018.

Analysis The existing case law and regulations for charitable deductions under Section 170 have long provided that charitable deductions must be reduced by any consideration received in return. However, when the benefit is simply a reduction in state tax or state tax credit, the answer was less clear. The IRS had actually issued several pieces of informal guidance coming to the conclusion that state programs offering tax benefits for charitable contributions did not reduce the federal charitable deduction.

The IRS noted in the preamble that these IRS Chief Counsel opinions were not formal published guidance, and the Chief Counsel had considered the issue at a time when both state tax deductions and charitable deductions were unlimited, although the charitable deduction may have provided a better result for those taxpayers that were subject to the Alternative Minimum Tax. The IRS said that the issue needed to be reconsidered in formal guidance because of the changes made by the TCJA.

The proposed regulations draw a clear line between contributions that simply reduce income for state and local tax purposes and contributions for which the state actually offers a credit against tax. The de minimis threshold also allows a limited amount of state tax credits to reduce state liability without affecting the charitable deduction.

Grant Thornton Insight: The 15% de minimis threshold operates as a cliff. It does not provide an exemption for the first 15% of value for any state credit program. It is instead all or nothing. If the tax credits received represent 15% or less of the value of the contribution, then there is no reduction in the charitable deduction. If the tax credits received represent 16% of value, then the deduction is reduced by the full amount of the tax credits received.

For more information contact: Mike Jackson
Partner, Private Client Services
T +1 215 701 8890

Dustin Stamper
Managing Director
Washington National Tax Office, Grant Thornton LLP
T +1 202 861 4144

Tax professional standards statement
This content supports Grant Thornton LLP’s marketing of professional services and is not written tax advice directed at the particular facts and circumstances of any person. If you are interested in the topics presented herein, we encourage you to contact us or an independent tax professional to discuss their potential application to your particular situation. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed herein. To the extent this content may be considered to contain written tax advice, any written advice contained in, forwarded with or attached to this content is not intended by Grant Thornton LLP to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

The information contained herein is general in nature and is based on authorities that are subject to change. It is not, and should not be construed as, accounting, legal or tax advice provided by Grant Thornton LLP to the reader. This material may not be applicable to, or suitable for, the reader’s specific circumstances or needs and may require consideration of tax and nontax factors not described herein.

Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Grant Thornton LLP assumes no obligation to inform the reader of any such changes. All references to “Section,” “Sec.,” or “§” refer to the Internal Revenue Code of 1986, as amended.