In the aftermath of the $10,000 state and local income tax deduction limitation imposed by the Tax Cuts and Jobs Act (TCJA), high-tax states began creating legislation to reduce the impact on their residents. The most prevalent workaround to date has included establishing state-and-local-government-run charitable contribution funds. The legislation allowed for donations to the funds to produce a federal charitable deduction on the resident taxpayer’s federal income tax return. This would allow the state to collect its full tax revenue and allow taxpayers to reduce their federal tax liability via a charitable contribution deduction. However, new IRS regulations recently went into effect, leaving high-tax states looking for new solutions.
IRS Disallows Federal Deductions When State Tax Credits are Involved
The IRS allude to its plans to challenge the state charitable contribution funds in Notice 2018-54. Relying on the substance over form analysis, the IRS suggested that donations to newly created funds would not be treated as bona fide charitable contributions eligible for a federal deduction.
However, in a change of policy, on August 23, 2018, the Treasury released proposed regulations under Internal Revenue Code (IRC) Section 170 disallowing a federal deduction to the extent the taxpayer receives a state tax credit. Now relying on the quid pro quo doctrine rather than the substance over form doctrine, taxpayers must exclude — dollar-for-dollar — any state or local tax credits they receive from the contribution.
For example, if a taxpayer contributes $1,000 to a state-run charitable fund and receives an $850 state tax credit, the $850 should be considered a benefit reducing the federal deduction (for federal tax purposes the contribution would only be eligible for a deduction on $250). A similar proposed regulation under IRC Section 642 applies this limitation to payments made by trusts and estates.
This limitation does not apply to de minimis state tax credits of 15% or less of the contribution. Additionally, businesses that make business-related payments to charities or government entities may still be able to deduct the payments as business expenses under IRC Section 162.
New Proposed Regs for Charitable Deductions Paint with a Broad Brush
Unfortunately, the proposed regulations in Section 170 also apply to charitable funds that were established well before the TCJA’s state and local tax deduction limitation came into play.
Prior to the TCJA, many states included the option for making donations to state programs, such as school tuition scholarship programs and natural resource preservation, that allowed a state tax credit and federal deduction. Under pre-TCJA case law and IRS rulings, the tax benefit of a state charitable contribution was generally not regarded as a return benefit that reduced the federal deduction. For example, in the 2011 case of Tempel v. Commissioner, the Tax Court ruled that a state tax credit is not an accession to wealth that results in income, and the transfer of state tax credits does not represent a right to receive income from the state.
The proposed regulations went into effect on August 27, 2018. Pursuant to the four-day delay, some tax practitioners took the position that any contributions made prior to this date may be eligible for the full deduction. New York state issued a statement providing guidance for residents to make last-minute donations to the newly created state charitable fund. It is unclear whether the IRS will honor these last-minute contributions. The quid pro quo doctrine is well established law and the IRS considers these proposed regulations as a means to provide clarity, not to establish new policy.
Tax Reform 2.0 and Its Impact on State and Local Tax
On September 10, 2018, bills for another round of tax cuts as a part of “Tax Reform 2.0” were released, including language intended to make the state and local tax deduction limitation permanent. Connecticut, Maryland, New Jersey and New York have filed a lawsuit against the federal government challenging the limitation as unconstitutional.
However, until further guidance is issued through the courts or additional legislation, taxpayers should consider other avenues of relief besides contributing to state-and-local-government-run charitable funds.
Read our blogs on other state workarounds:
Connecticut Passes State and Local Tax Deduction “Workaround”
New York Issues Guidance on Payroll Expense Tax “Workaround” for State and Local Tax Deduction Cap
Please contact a member of your service team, or contact Cynthia Pedersen at firstname.lastname@example.org for further discussion.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.