Sometimes the law of unintended consequences is difficult to correct after the fact. The most recent example may be the 2017 Tax Cuts and Jobs Act’s $10,000 annual limitation on state and local tax deductions claimed by individuals. As a result, legislatures in several high-tax states either proposed or have enacted legislation generally called “SALT cap workarounds.” In most cases, the legislation either gives state residents a state or local tax credit for a donation to a specified non-profit entity in lieu of, for example, a property tax deduction, or it imposes an entity-level income tax on pass-through entities doing business in the state, in lieu of imposing the state income tax at the partner/S corporation shareholder level. Connecticut and Wisconsin are examples of the latter. The Internal Revenue Service responded quickly by issuing a warning notice in June 2018 and then proposed regulations under IRC Section 170 on August 23 (Proposed Regulations) (available here). Those pronouncements, to the extent they are legally binding, effectively disallow or limit the federal charitable contribution deduction if the individual donor receives or expects to receive, directly or indirectly, a state or local tax credit in return for the donation to an approved non-profit entity. Unfortunately, the IRS – perhaps unintentionally – cast its net far too widely and included individual taxpayers’ donations to long-standing IRS- and state-approved scholarship granting organizations or similar non-profit entities (SGOs) in approximately 18 states, including Alabama.
On September 5, 2018, the IRS issued a news release and a “FAQ” intended to calm the fears of business donors by confirming that a donation to an SGO or other qualified charitable organization by a “business taxpayer” (an undefined term) may continue to qualify as a trade or business expense deductible under IRC Section 162, thus avoiding the “quid pro quo” limitation of the Proposed Regulations. Then on December 28, the IRS issued Revenue Procedure 2019-12 (available here) giving further assurance to C corporation donors but little comfort to pass-through entity donors, such as LLCs, limited partnerships and S corporations, with individual owners (PTEs).
The preamble says the IRS is providing a “safe harbor” under Section 162 for certain payments made by a C corporation or a “specified pass-through entity” to or for the use of an organization described in IRC Section 170(c) even if the donor receives or expects to receive a state or local tax credit in return for the payment. Section 3 of the Revenue Procedure affirms that a C corporation donor “may” treat the donation as “meeting the requirements of an ordinary and necessary business expense for purposes of section 162(a) to the extent of the credit received or expected to be received,” whether the credit is for a state or local income tax or another tax. On the other hand, the safe harbor in Section 4 for “specified pass-through entities” is of limited benefit, and in the case of states such as Alabama that grant only an individual or corporate income tax credit for donations to SGOs, not helpful at all to the individual owners.
On the other hand, if the state scholarship program or other approved organization offers donors a credit against a non-income tax, such as a state or local excise or sales/use tax or property tax, then the specified PTE donor “may” treat the donation as a deductible trade or business expense under Section 162. The key distinctions are (a) the tax is imposed on the entity rather than on its individual owners, and (b) the creditable tax is not an income tax. Thus, since PTEs aren’t subject to income tax in Alabama (except in very limited circumstances for S corporations) and the only tax credit currently offered to SGO donors is a state income tax credit, the safe harbor doesn’t provide any practical benefit to PTE donors with individual owners. The Alabama Legislature should revisit this in the upcoming regular session.
Readers should also note the quirky effective date of the Revenue Procedure, which applies to donations made on or after January 1, 2018, by both C corporations and specified PTEs. So, a rather odd dichotomy seems to be created -- between individual donors and PTE donors owned by individuals. As mentioned, the Proposed Regulations currently grandfather 2018 donations made by individuals to qualified SGOs and certain other non-profit entities before August 27, 2018, while the Revenue Procedure oddly seems to disallow the deduction for donations made by PTEs owned by individuals even if made within that same time period.
2018 Donations to SGOs. It appears, at least as of today, that 2018 donations made by Alabama resident individuals to qualified SGOs before August 27, 2018, are grandfathered, meaning donors may qualify for both the state income tax credit and the IRC Section 170 charitable contribution deduction, subject to other limitations. The quirk in the effective date for donations by PTEs with individual owners is noted above. We hope to receive a favorable correction from the IRS within the next few weeks.
2019 Donations to SGOs. In all events, the state income tax credits granted by the Alabama Accountability Act remain intact, and a new $30 million allocation is now available on the Alabama DOR’s “My Alabama Taxes” website, subject to normal limitations. We have received numerous inquiries about that and whether individual donors may continue to claim a federal charitable contribution deduction for donations to SGOs that generate a state income tax credit. The Proposed Regulations would generally deny the deduction. But recall that the Proposed Regulations are just that – proposed regulations. They have been challenged in court, as has the Internal Revenue Code subsection creating the $10,000 SALT cap. At this point, it’s uncertain whether and when these proposed regulations will be finalized or in what form, or whether certain SGOs may ultimately be carved out or if donors will be granted a delayed effective date before the limitation on charitable contribution deductions will apply, or otherwise.
Unlike temporary or final Treasury regulations, proposed regulations don’t generally carry the force of law. Thus, if a taxpayer takes a position that conflicts with a proposed regulation and the IRS challenges the taxpayer’s position, a reviewing court will treat the proposed regulation as the IRS’ position but will not give the proposed regulation additional weight or deference. Many commenters (including our law firm) asked the IRS to delay the effective date of the final regulations to a date significantly later than the proposed effective date of August 27, 2018. However, taxpayers who choose to disregard the Proposed Regulations for contributions made during 2019 take the risk that the eventual final regulations may be retroactive to the proposed effective date.
Closing Thoughts. Lesley Searcy, Executive Director of the Alabama Opportunity Scholarship Fund (AOSF), which is a Bradley client, stated that “we appreciate the efforts of the Treasury Department and the IRS to help ensure scholarship programs like AOSF can continue meeting the needs of low income students. These are important programs to hundreds of thousands of children throughout the country. We’re counting on C corps to continue their support with added confidence based on the recent Treasury guidance.”
As for potential PTE donors, it’s questionable whether a court would validate the Proposed Regulations’ attempt to disallow the deduction for a PTE’s donation to an SGO if the payment clearly qualified as a Section 162 trade or business expense. Arguably, the Revenue Procedure has disregarded traditional tax rules that characterize the expense as a valid (or not) trade or business expense at the entity level, rather than the partner/shareholder level. It’s also unclear whether individual donors who have less than $10,000 in state and local tax deductions for 2019 should even be subject to the Proposed Regulations, and we understand from our sources that the IRS may address this issue next.
We expect further developments at the federal level soon, and we may also see the Alabama Legislature step in this spring to consider additional or different ways to encourage donations to fund scholarships for underprivileged children through SGOs operating in Alabama. The views expressed in this alert are those of the authors only and don’t necessarily represent the views of their law firm, their clients, or other organizations with which they are affiliated. Nor do their views constitute binding legal opinions. Please consult your personal tax advisor with respect to both 2018 and 2019 donations to AOSF or other qualified SGOs.