Treasury Regulations Shut Down Most End Runs around New State Tax Deduction Limits
October 2020 Update:
On August 11, 2020 the IRS issued Final Regulations (TD 9907) which reflect only minor changes and clarifications to the Proposed Regulations issued in 2018 and 2019. The Final Regulations include all of the major provisions introduced in the original proposed Regulations, which are discussed below in our article published in August 2018.
As discussed in the earlier article, the Final Regulations focus on the treatment of payments made under charitable programs created by some states in an effort to circumvent the $10,000 cap on the deductibility of state and local taxes as itemized deductions. At this time, the IRS has not issued any guidance related to pass-through entity state income taxes paid at the entity level for which an owner is given a credit (in part) on his individual income tax return, as is the case under Connecticut’s pass-through entity tax regime.
One of the features in December’s Tax Cuts and Jobs Act (“TCJA”) that gathered the most attention and disagreement was a section that capped the deductibility of state and local taxes at $10,000. Almost immediately, some new state and local tax arrangements began cropping up that seemed designed to offer taxpayers the ability to circumvent this new TCJA limitation. (Some such programs already existed, but overall they saw dramatically increased activity.) As a result, the Treasury Department warned early this summer that it planned to issue regulations curbing what it saw as abuse of these programs. Last week, it followed through by issuing REG-112176-18, the topic of this article.
Background – the capping
Proponents of the TCJA’s new $10,000 cap on state and local taxes may argue that because most categories of itemized deductions were eliminated or significantly restricted, and the standard deduction (an alternative to itemized deductions) was greatly increased (it is nearly doubled), many or even most taxpayers will not need the state and local tax deduction. Meanwhile, opponents quickly realized that this new limitation disproportionately impacts taxpayers who reside in states with high, rather than low, state and local taxes (but proponents would counter that before the TCJA, residents of low-tax states were subsidizing those in high-tax states, because the low-tax state residents received less of a state tax deduction). Because high-tax states tend to lean Democrat, and the TCJA was Republican-propelled, the cap has been characterized as an indirect assault on Democrat leadership by Republican leadership.
Some states’ reactions – the uncapping
One reaction to this feature is the very recent initiation by several states of an arrangement that essentially re-characterizes the payment of state taxes to that of a charitable contribution – a category of federal itemized deductions that remained unscathed in the TCJA. Any such conversions would sidestep the new cap on state and local taxes. A simplified example of these programs is as follows: Working with specific charities or a newly-formed state agency, taxpayers can make payments to the charity or agency in exchange for the state agreeing to reduce that taxpayer’s state taxes by the amount (or a percentage) of the contribution. That reduction is accomplished in the form of a tax credit. Technically, the taxpayer made a charitable contribution, but because it did so only by funneling the money into a state government-approved destination, it also has characteristics of a state tax payment.
Federal countermeasures – gluing the lid
The TCJA was passed using estimates of its revenue impact, including how much money would be raised by capping the state and local tax deduction. Tax credit programs like the one described have existed in some states for many years, but because so many came to life as a direct response to the TCJA, it was seen as an end run around the new state and local tax cap, and a scheme that would put a sizeable dent in the expected revenue collections Congress counted on when passing the TCJA.
In June, the Treasury Department issued Notice 2018-54, warning taxpayers that it intended to issue regulations addressing the proper federal tax characterization of payments made to state credit programs. This month, it did just that – with the issuance of Proposed Regulations REG-112176-18.
REG-112176-18 reminds taxpayers that charitable contributions are not allowed for the portion of a contribution that represents something provided back to the taxpayer. (It is for this reason that letters from charitable organizations that acknowledge and thank a donor for gifts nearly always contain a statement pointing out that nothing was provided to the donor in exchange for the gift. Others, when something was provided in exchange, describe the exchange and sometimes provide an estimated value of it.) Treasury views the provision of a credit to the donor in return for a contribution as clear evidence of a quid pro quo exchange, which should nullify part of the contribution under long-standing federal tax law.
REG-112176-18’s new restriction
In pointing out the quid pro quo characteristics of certain tax credit arrangements, REG-112176-18 explains that a deductible contribution to a charity must be reduced by the amount of the state tax credit the donor expects to receive. Only the portion of the contribution that exceeds that credit will qualify as a contribution. The proposed regulations provide a de minimis exception, allowing full deductibility in the case of credits that do not exceed 15% of the donation. (Note that this de minimis exception is an “all or nothing” one, in that donors with credits that do exceed 15% will not receive the benefit of the first 15%. This is shown in the examples below.) The proposed regulations apply only to contributions made after August 27, 2018, and they apply regardless of whether a credit program was created before or after the issuance of the TCJA.
John Doe contributes $50,000 to a charity as part of an arrangement by which he will receive a $20,000 state tax credit. Assuming he made no other contributions, the proposed regulations would cause his federal deduction for charitable contributions to be no greater than $30,000 ($50,000 – $20,000).
Jane Doe contributes $50,000 to a charity as part of an arrangement by which she will receive a $7,500 state tax credit. Assuming she made no other contributions, the proposed regulations would allow her federal deduction for charitable contributions to be as high as the full $50,000. (Because her $7,500 credit is no more than 15% of the amount donated, the new proposed regulation does not nullify any part of her deduction.)
Taxpayers who hope to replace part of their lost state and local tax deductions by participating in credit programs that promise the exchange of a state tax deduction for a charitable contribution should become familiar with Proposed Regulations REG-112176-18. Its new restriction on a possible work-around to the Tax Cuts and Jobs Act’s $10,000 cap on state and local tax deductions will remove or limit the effectiveness of these programs.
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