The US Internal Revenue Service (IRS) issued Notice 2018-54 (Notice) announcing its intention to propose regulations that could impact the viability of the charitable contribution workaround to the state and local tax deduction limitation enacted in the Tax Cuts and Jobs Act (the “Tax Act”). The annual $10,000 limitation ($5,000 for individuals) hit taxpayers in certain states particularly hard and several states such as New York, California, Illinois, Rhode Island and Vermont quickly responded by proposing legislation that would allow their citizens to make charitable contributions to state-created funds and receive credits that could be applied against their state tax liabilities. On April 12, 2018, New York became the first state to sign into law provisions that would allow individuals to deduct 85% of the donations they make to certain newly created funds and charitable organizations.
The Notice reminds taxpayers to “be mindful that federal law controls the proper characterization of payments for federal income tax purposes” and warns 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 tenor of the Notice strongly suggests that the IRS will distinguish Chief Counsel Advice Memorandum 201105010 (CCA), released February 4, 2011, which addressed whether a payment to a state agency is considered a charitable contribution if the payment entitles the taxpayer to a state tax credit and concluded that a reduction in tax liability attributable to a charitable contribution of cash and appreciated stock is not consideration that might constitute a quid pro quo for purposes of the charitable deduction. However, the CCA cautioned that “there 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.”
Given the reference in the Notice to substance-over-form principles, we expect that the proposed regulations will view the states’ charitable deduction workaround as an appropriate circumstance to warrant recharacterization of the charitable deductions as state tax payments subject to the Tax Act’s limitation.