Under the Tax Cuts and Jobs Act, Congress amended Code Section 164 was amended to add a $10,000 limit on individual itemized deductions for state and local taxes (“SALT”) for tax years 2018 to 2025. This limitation appears to disproportionately affect high-income residents of states with high income taxes and property taxes. It has motivated lawmakers in states such as California, Connecticut, Illinois, New York, New Jersey, and Oregon to propose and, in some cases, pass legislation that would create workarounds to the limitation found in Section 164(b)(6). In general, these workarounds would allow taxpayers to receive a full or partial state or local tax credit in exchange for certain qualifying charitable contributions approved by the relevant state. Additionally, some states such as New York and Connecticut have taken measures to shift the incidence of tax from the individual to a business entity (as the $10,000 SALT deduction limitation applies to individuals, not business entities such as corporations and partnerships) in an effort to reduce the federal tax increases otherwise resulting from the SALT deduction limitation. The IRS has taken notice of the charitable contribution workarounds and, in response, issued Notice 2018- 54 (the “Notice”) on May 23, 2018.
The Notice informs taxpayers of the Treasury Department’s and the IRS’s intent to propose regulations that address the federal income tax treatment of certain payments to state-approved funds for which taxpayers receive a credit against their state and local taxes. The Notice cautions taxpayers that “[d]espite these state efforts to circumvent the new statutory limitation on state and local tax limitation, taxpayers should be mindful that federal law controls the proper characterization of payments for federal income tax purposes.” While the Notice does not indicate the exact nature of the proposed regulations, it states that the proposed regulations “will make clear that the requirements of the Internal Revenue Code, informed by substance-over-form principles, govern the federal income tax treatment of such transfers.” The proposed regulations are expected to be released relatively soon.
But the Notice is significant in and of itself. The Notice is the harbinger of a proposed regulation that purportedly would delineate the circumstances for diverging from the result in Chief Counsel Advice 201105010 (Oct. 27, 2010), a non-precedential memorandum which addressed the issue of whether a cash payment to either a state agency or a charitable organization in exchange for a transferable state tax charitable credit could qualify for a charitable contribution for federal income tax purposes. In that memorandum, the IRS Office of Chief Counsel concluded that the fact that the taxpayer received state tax credits in return for its donation did not disqualify the donation from being characterized as a deductible charitable contribution for federal income tax purposes. Notwithstanding this conclusion, the Advice memorandum explicitly provides that “[t]here may be unusual circumstances in which it would be appropriate to recharacterize a payment of cash or property that was, in form, a charitable contribution as, in substance, a satisfaction of tax liability.” The proposed regulation is expected to set forth and identify those unusual circumstances in greater detail.
In hopes of improving its chances for withstanding scrutiny under the forthcoming proposed regulation, California legislators have amended proposed legislation that would provide a state tax credit for charitable contributions. Prior to the Notice, California SB 227 provided an 85% state tax credit for charitable contributions to the California Excellence Fund. Under the current version that was amended subsequent to the issuance of the Notice, California SB 227 provides a 85% state tax credit for amounts contributed to the Local Schools and Colleges Voluntary Contribution Fund. This Fund would have two subaccounts, the Baseline Schools and Colleges Subaccount and the Supplemental Schools and Colleges Subaccount. Generally, the funds from the Baseline Schools and Colleges Subaccount would be used to reimburse the state’s General Fund for its constitutional minimum funding requirements for local educational agencies and community college districts. The funds from the Supplemental Schools and Colleges Subaccount would be allocated to local educational agencies and community college districts based on average daily attendance.
This change in California’s proposed legislation appears to be designed to conform with the state tax credit programs adopted by other states prior to the enactment of the Tax Cuts and Jobs Act, which presumably resulted in deductible charitable contributions for federal income tax purposes. Several of these legacy states probably would not be categorized as being disproportionately affected by the SALT deduction limitation. Thus, if the Treasury Department and the IRS issue a regulation that broadly disallows a charitable contribution deduction under circumstances similar to the one proposed under current California SB 227, such a regulation could result in residents of other states losing their charitable contribution deduction for such similar donations.
States that conform their tax credit programs to similar programs that qualified for the charitable contribution deduction prior to the Tax Cuts and Jobs Act could put the IRS and the Treasury Department in an interesting spot. Will the forthcoming proposed regulation attempt to take away the charitable contribution deduction for all taxpayers that receive state tax credits in exchange for their donations? Or will it try to formulate a method that distinguishes between programs adopted by states subsequent to the Tax Cuts and Jobs Act and programs adopted in legacy states? An affirmative response to the former could provide some residents of disproportionately affected states with a small measure of schadenfreude (i.e., pleasure or satisfaction derived from the misfortune of another), and an affirmative response to the latter may result in administrative challenges and litigation. We will find out when the proposed regulation is published.