The United States Treasury Department and the IRS issued Prop. Reg. §1.170A-1(h)(3) (the “Proposed Regulations”) in late August, in response to state legislation proposed after the enactment of limitations on state and local tax deductions imposed by the 2017 federal tax legislation. The rules in the Proposed Regulations are purportedly based on longstanding federal tax law principles, which apply equally to taxpayers regardless of whether they are participating in new state and local tax credit programs designed to work around the new tax law (“Workarounds”) or preexisting state and local tax credit programs (“Historical Programs”). This Nelson Mullins Tax Alert summarizes the guidance provided by the Proposed Regulations and identifies certain areas of concern to taxpayers and their professional advisors.
Many states have historically provided state tax incentives for charitable giving. These programs have included state tax incentives for donations for scholarships, financial aid, domestic violence shelters, and other programs of interest to states. For purposes of this Tax Alert, these state tax incentive programs will be referred to as the “Historical Programs.” In addition to state tax credit incentives, the Historical Programs have theoretically provided donors with a charitable deduction on their federal income tax returns, though the validity of such deductions was initially a point of uncertainty. In informal, nonbinding pronouncements, IRS agents initially declined to determine whether taxpayers were permitted to take a federal charitable deduction for donations that also provided the taxpayer with a state tax credit and instead asked the national IRS office to provide guidance. See, e.g., Chief Counsel Advice 200435001; 200238041. In Chief Counsel Advice 201105010 published on October 27, 2010, the IRS provided guidance on these Historical Programs by permitting federal charitable deductions for these types of donations. The IRS cited McLennan v. United States, 23 Cl. Ct. 99 (1991), Skripak v. Comm’r, 84 T.C. 285 (1985), Allen v. Comm’r, 92 T.C. 1 (1989), and Browning v. Comm’r, 109 T.C. 303 (1997), for the proposition that a state tax deduction does not reduce or eliminate a federal charitable deduction by the value or amount of the state tax deduction. The IRS determined that based on these cases, as well as prior rulings discussing the interplay of federal charitable deductions and state tax credits (e.g. Revenue Ruling 79-315 and Snyder v. Comm’r, 894 F.2d 1337 (6th Cir. 1990)), a state tax credit does not reduce or eliminate a federal deduction (by the value or amount of such state tax credit) because if the state tax credit reduced a taxpayer’s state or local tax liability, the taxpayer’s state or local tax deduction under Section 164 of the Internal Revenue Code would be smaller by that amount. The IRS posited that the payment to a state agency or charitable organization in return for a state tax credit could be treated as qualifying either as a charitable deduction under Section 170 of the Internal Revenue Code or as a payment of state and local taxes (“SALT”) deductible under Section 164 of the Internal Revenue Code.
The Tax Cuts and Jobs Act of 2017 (the “TCJA”) raised several issues in light of the IRS’s stated position on this issue. The new law caps the previously unlimited SALT deduction, at $10,000 annually. However, the TCJA did not impose any corresponding type of cap on charitable deductions. Thus, the symmetry between the SALT deduction and charitable deductions that led to the IRS’s previous position no longer applies.
Legislatures in states with high income and property tax rates, such as California, Connecticut, Illinois, New York, and New Jersey, wasted little time trying to circumvent this new asymmetry between the SALT deduction and charitable deductions. By providing their residents with an opportunity to exploit the IRS’s previous policy as put forth in Chief Counsel Advice 201105010, these states created programs to enable their residents to make charitable deductions to a state or local government in exchange for offsetting state tax credits. These so-called “Workarounds” were intended to circumvent or workaround the TCJA’s newly imposed cap on SALT deductions.
Charitable Deductions under Section 170 - The Quid Pro Quo Rule. By way of further background, Section 170 of the Internal Revenue Code provides that a taxpayer is entitled to a deduction for contributions made to charities by donors with donative intent. Charitable contributions include donations made to Section 501(c)(3) nonprofits and to federal, state, or local governments for public purposes. Generally, the amount of a charitable deduction is equal to the amount of money or fair market value of property donated to charity reduced by the fair market value of goods or services provided to the donor by the recipient. This reduction, known as the “quid pro quo” rule, prevents donors from taking a charitable deduction for the fair market value of goods and services they receive from the charitable recipient. The quid pro quo rule also applies to goods and services given to the donor by others in exchange for the charitable deduction. However, the rule does not address charitable deductions. In such cases, taxpayers are not required to reduce their federal charitable deductions by the amount of the tax savings they receive from the federal government. As briefly discussed above, federal tax law had previously disregarded state tax benefits in determining whether the taxpayer received a quid pro quo.
The Proposed Regulations
As a precursor to the Proposed Regulations, the IRS issued Notice 2018-54 on June 11, 2018, announcing its intention to issue proposed regulations on the Workarounds and the Historical Programs. The timing of this Notice may have been to give warning to taxpayers in the process of making their second quarter estimated tax payment due on June 15. On August 23, 2018, the Treasury Department and the IRS issued Prop. Reg. §1.170A-1(h)(3). In the Preamble to the Proposed Regulations, the Treasury and the IRS stated that “when a taxpayer receives or expects to receive a state or local tax credit in return for a payment or transfer to an entity listed in section 170(c), the receipt of this tax benefit constitutes a quid pro quo that may preclude a full deduction under section 170(a).” The Preamble noted that the Proposed Regulations are intended to not just cover the Workarounds but also the Historical Programs, noting that “[a]lthough Notice 2018-54 was issued in response to state legislation proposed after the enactment of the limitation on state and local tax deductions under section 164(b)(6), the rules in these proposed regulations are based on longstanding federal tax law principles, which apply equally to taxpayers regardless of whether they are participating in a new state and local tax credit program or a preexisting one.”
The Proposed Regulations provide that a “taxpayer’s charitable deduction under section 170(a) is reduced by the amount of any state or local tax credit that the taxpayer receives or expects to receive in consideration for the taxpayer’s payment or transfer.” This general rule only applies to state or local tax credits that exceed 15% of the taxpayer’s cash payment or the fair market value of property contributed by the taxpayer (the “Credit Threshold”).
Example 1: B, an individual, transfers a painting to Y, an entity listed in Section 170(c). The painting has a fair market value of $100,000. Under a state program, B receives or expects to receive a state tax credit equal to 50% of the fair market value of the painting. Under the Proposed Regulations, B’s charitable deduction would be reduced by 50%. B could then deduct $50,000 pursuant to Section 170(a) of the Internal Revenue Code.
Example 2: In Example 1, instead of receiving or expecting to receive a state tax credit equal to 50% of the fair market value of the painting, the state program provides a state tax credit equal to 10% of the fair market value of the painting. Under the Proposed Regulations, because the credit received by B is under the Credit Threshold, B’s charitable deduction would not be reduced, and B could deduct the full $100,000 pursuant to Section 170(a) of the Internal Revenue Code.
The Proposed Regulations provide a different rule for state and local programs that provide a state or local tax deduction instead of a credit. Under the Proposed Regulations, a taxpayer is not required to reduce his or her charitable deduction by the amount of the deduction. However, if the state or local tax deduction exceeds the amount of the taxpayer’s cash payment or fair market value of the property contributed, the taxpayer must reduce his or her charitable deduction by such excess.
Example 3: C, an individual, donates $1,000 to Z, an entity listed in section 170(c). In exchange for the payment, under applicable state law, C is entitled to receive a state tax deduction equal to the amount paid by C to Z. C is entitled to take a $1,000 charitable deduction and is not required to reduce the federal charitable deduction by the state tax deduction.
The Preamble to the Proposed Regulations posits that the different treatments for state and local tax credits and state and local tax deductions is appropriate based on the significant tax benefits and incentives that tax credits create, as compared to the modest benefits provided by state or local tax deductions.
The Proposed Regulations also subject trusts and estates to these new rules. The Proposed Regulations apply to amounts paid or property transferred by a taxpayer after August 27, 2018.
Ordinary and Necessary Business Deductions under Section 162. Following the Proposed Regulations, questions arose as to whether deductions for business-related payments to charities or government entities under Section 162 that qualify for state or local tax credits would also be affected under the IRS’s new policy. In response, on September 5, 2018, the IRS issued a News Release stating that the general deductibility of these business expenses are unaffected by the Proposed Regulations. The IRS specifically noted that “[t]he business expense deduction is available to any business taxpayer, regardless of whether it is doing business as a sole proprietor, partnership or corporation, as long as the payment qualifies as an ordinary and necessary business expense.”