IRS Issues Final Regulations for SALT Charitable Contribution Workarounds
By Michael D'Addio, Principal, Tax & Business Services
The Tax Cuts and Jobs Act (TCJA) limits the deduction for state and local income taxes (SALT) for those living in states and localities with high income or property taxes. In reaction to this, some states developed “workarounds” to permit their residents to get a larger tax benefit by re-characterizing their payments as something other than SALT.
One popular approach is a program under which contributions to certain charitable organizations entitle donors to a tax credit against state and local income taxes or property taxes. This effectively reduces the amount subject to the SALT limitation and converts it to a charitable deduction that is not subject to a dollar cap. It should be noted that several states had these types of programs, providing a credit of 70% to 100% of the amount contributed, even prior to enactment of the TCJA.
In 2010, the IRS chief counsel advised that, under certain circumstances, a taxpayer could take a charitable contribution deduction for the full amount of a contribution made in exchange for a state tax credit, without subtracting the value of the credit received in return. Additionally, IRS chief counsel has argued in a number of Tax Court cases that a state or local tax credit that reduces a tax liability is not an accession to wealth includible in income under IRC section 61, or an amount realized for section 1001. This position was agreed to by the Court in several cases.
The IRS issued proposed regulations in August 2018, which questioned the reasoning of the 2010 chief counsel’s advice and required, in certain circumstances, that a charitable contribution deduction be reduced by an associated state and local tax credit. These regulations have just been finalized and follow the original proposed regulations in most significant respects.
In addition, the Service also issued Notice 2019-12, which states its intention to issue proposed regulations permitting taxpayers to elect to treat the disallowed portion of the contribution as a payment of state and local taxes.
While the final regulations take effect 60 days after publication in the Federal Register, the regulations are retroactive to contributions made after August 27, 2018.
Neither the regulations nor the IRS Notice address the issue of other workarounds, e.g., a pass-through entity tax (as in Connecticut) or additional payroll tax (as in New York). Prior statements from Treasury indicate that these workarounds are on their radar.
The final regulations provide that:
- A taxpayer contributing to a charity and receiving a tax credit against state or local taxes in excess of 15% of the contributed amount must reduce the charitable deduction by the amount of the SALT credit. This rule allows a SALT credit of up to 15% without adjusting the charitable contribution deduction. The 15% threshold represents the value of a state tax deduction for the contribution, which is apparently an acceptable benefit.
- A taxpayer receiving a state or local tax deduction benefit is not required to reduce its federal contribution deduction. However, a reduction is required where one receives an “excess state or local deduction.” This is a deduction allowed by the state, which exceeds the amount contributed to the charity.
Commenters noted that a taxpayer who might otherwise be able to deduct all or a portion of state and local taxes would be harmed if there is a reduction to both the contribution deduction (under the final regulation) and the SALT deduction (since only a net amount of SALT is actually paid). Notice 2019-12 addresses this problem by permitting an election to treat the amount by which the charitable deduction is reduced for a SALT credit as a payment of state or local tax. This effectively restores the SALT deduction, which is beneficial only if the taxpayer is otherwise under the $10,000 SALT deduction cap. The elected SALT deduction is allowed in a year to the extent the resulting credit is applied under state and local law to offset the SALT liability for the current tax year or the preceding tax year. If state law permits a carryover, then it is treated as a SALT deduction in the future year in which it is allowed.
Assume that Individual A makes a $7,000 cash contribution to an IRC section 170(c) exempt entity and receives a $7,000 SALT credit that can be carried forward under state law for three tax years. If Individual A has $5,000 of state tax liability in both the current year and next tax year, A will use $5,000 of the credit in the current year and $2,000 in the following year. The consequence under the final regulation and the Notice are that:
- Under the final regulations, the contribution deduction is reduced to zero since the SALT credit exceeds 15% of the $7,000 contribution.
- Despite the fact that the SALT deduction would generally be zero (since the credit eliminates the state tax and no state tax has been paid), under Notice 2019-12, A can elect to treat the $7,000 contribution reduction as a payment of state tax. The corresponding state tax deduction is matched to the use of the credit. This treats $5,000 as a SALT payment in the current year and $2,000 as a SALT payment in the following year.
The Notice states that this election does not apply to a transfer of property.
Those who may have been subject to a contribution reduction under the proposed regulations in 2018 should look to see if an amended return should be filed to take advantage of the rule found in Notice 2019-12.
If you have any questions, please contact your Marcum tax professional to guide you through these rules.