In May, the IRS issued Notice 2018-54 indicating that it is aware of “state efforts to circumvent the new statutory limitation on state and local tax deductions” by allowing taxpayers “to make transfers to funds controlled by state or local governments, or other transferees specified by the state, in exchange for credits against the state or local taxes that the taxpayer is required to pay.”
The IRS is interested in these programs because of a recent rush by high-tax states to enact similar programs that provide a state income tax credit for charitable contributions that also qualify for a federal income tax deduction. The IRS believes that these programs are merely an effort to offset the impact of the cap on state and local tax deductions imposed by the new tax bill, the “Tax Cuts and Jobs Act, (the “TCJA”). Specifically, the TCJA limits the deduction for state and local taxes to $10,000 per return.
The Alabama Accountability Act of 2013 (which was enacted nearly 5 years prior to the TCJA) uses a similar funding mechanism whereby a taxpayer may receive a credit against state taxes in exchange for making contributions to certain “Scholarship Granting Organizations” (“SGOs”) that are designated by the state. Because each SGO has also been designated as a Section 501(c)(3) organization by the IRS for federal income tax purposes, the taxpayer may also be eligible for a deduction against its federal income tax for its contributions to the SGOs. Prior to Notice 2018-54, the IRS appeared to acquiesce that the taxpayer could claim a federal income tax deduction despite the receipt of a state income tax credit. See IRS Chief Counsel Memorandum 201105010.
While Alabama's program does provide “credits against the state or local taxes that the taxpayer is required to pay” in exchange for contributions to the SGOs which are “specified by the state,” it seems illogical to conclude that the Alabama program, which was enacted in 2013, is intended to circumvent the changes to the tax code that went into effect earlier this year pursuant to TCJA. Despite this distinction, Alabama's program has undeniably garnered heightened interest following the recent changes to the tax code, as evidenced by the fact that all of the available credits for 2018 were claimed by February of this year. It is important to note that Notice 2018-54 is not law and does not disallow the federal income tax deductions associated with these programs. However, the notice warns taxpayers to “be mindful that federal law controls the proper characterization of payments for federal income tax purposes.” The notice also indicates that Treasury Department and the IRS intend to propose regulations addressing the federal income tax treatment of charitable contributions made in connection with these programs.
Despite its non-binding nature, Notice 2018-54 is a warning that the IRS is focusing its attention and scrutiny on these programs, and we would not be surprised if the IRS begins challenging the characterization of any federal deductions taken in connection with these programs, irrespective of if the program pre-dates the TCJA. Because any such challenges could potentially impact deductions for which Alabama taxpayers received state tax credits under the Alabama Accountability Act of 2013, we will continue to watch and keep you updated as this issue develops.