The IRS has finalized regulations that shut down strategies using state charitable programs to avoid the cap on state and local tax (SALT) deductions, but also offered relief for taxpayers who would lose both their charitable and SALT deductions under the rules.
The final regulations (T.D. 9864
) largely adopt proposed regulations issued last August, and generally require taxpayers to reduce their charitable deduction by the amount of state tax and local credits received in return. Notice 2019-12
proposes a safe harbor that would let taxpayers treat payments to state charitable programs as state tax payments so that they would remain deductible up to the $10,000 cap. Taxpayers can rely on the safe harbor immediately even though it has not yet been issued as a proposed regulation.
The Tax Cuts and Jobs (TCJA) capped the itemized deduction for state and local taxes at $10,000. With no limit on the charitable deduction, however, several states passed laws establishing charitable funds for state services that taxpayers can contribute to in exchange for state tax credits. This would allow taxpayers to replace a state tax payment with a charitable contribution and convert a state tax deduction into a charitable deduction.
The regulations provide that charitable deductions must be reduced by any state tax credits received in exchange for making the contribution. There is an exception for credits that do not exceed 15% of the gift. The regulations 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.
Commenters to the proposed regulations raised several concerns over the 15% exception, particularly its cliff effect. Credits that even marginally exceed 15% of the contribution are entirely disqualified from the exception. Some commenters argued this produces an unfair outcome and instead proposed that first 15% of all contributions should qualify for the exception. Others pushed for the threshold percentage to be raised.
No changes to the 15% threshold were adopted in the final regulations. The IRS reasoned that the threshold was based on the highest current marginal state and local tax rate, which does not exceed 15%, and was designed to confer a benefit that was generally equivalent to a state and local tax deduction. It considered tailoring the threshold to taxpayers’ specific jurisdictions, but determined that would be too complex and burdensome.
The IRS also received comments concerning state charitable programs that predate the TCJA, and thus could not have been intended to circumvent it. The rules do not explicitly distinguish between such programs and those created by states in response to the TCJA. The IRS cited the need to treat taxpayers fairly and consistently in defending the broad application of the rules.
Notice 2019-12 offers some relief for taxpayers who itemize and have not fully deducted against the $10,000 cap. The safe harbor allows them to treat the portion of a contribution that yields a credit, which would otherwise reduce their charitable deduction under the final rules, as a deductible state and local tax payment up to the $10,000 cap. Credits received in excess of state and local tax liability may be carried forward to subsequent years and treated in the same manner. The safe harbor does not apply to contributions of property.
The IRS also earlier provided a safe harbor (Rev. Proc. 2019-12) for businesses that give to the state programs to deduct their payments as ordinary and necessary business expenses under Section 162. The safe harbor allows C corporations to deduct payments up to the amount of tax credits received. Whether any amounts exceeding tax credits are deductible depends on the facts and circumstances. The safe harbor allows certain pass-throughs operating a trade or business to deduct payments up to the amount of state tax credits received for taxes other than income taxes.
The final new regulations are applicable for payments made on and after Aug. 27, 2018. The IRS is requesting comments on the proposed safe harbor under Notice 2019-12 by July 11, 2019, but taxpayers may rely on the guidance now.
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