Treasury Proposes Rules on Charitable Contributions and State and Local Tax Credits
On August 23, the U.S. Department of the Treasury issued proposed regulations on the federal income tax treatment of payments and property transfers under state and local tax credit programs. The proposed regulations would prevent charitable contributions from being used to circumvent the new limitation on state and local tax deductions.
These proposed regulations are in response to state legislation intended to help taxpayers avoid the $10,000 limitation on the deduction for state and local taxes under IRC Sec. 164 as amended by the Tax Cuts and Jobs Act (“TCJA”). The $10,000 limitation applies to individual taxpayers for tax years beginning after December 31, 2017, and beginning before January 1, 2026.
As previously announced in IRS Notice 2018-54, the proposed regulations intend to clarify that the Internal Revenue Code requirements govern the federal income tax treatment of the transfer by taxpayers to funds controlled by state and local governments.
The charitable deduction workarounds New York, New Jersey and Connecticut approved, following the new federal cap on deductions for state and local taxes are not acceptable to the federal government, and, as a result, under the proposed regulations, the amount otherwise deductible as a charitable contribution must generally be reduced by the amount of state or local tax credit received or expected to be received. A federal charitable deduction will only be allowed to the extent a contribution to a charity exceeds the amount of state tax credit generated by the contribution. When a taxpayer makes a charitable contribution and receives a valuable benefit in return, the taxpayer can only deduct the net value of that contribution.
These proposed regulations would also apply to payments made by trusts or decedents’ estates in determining the amount of their contribution deduction.
As described in the explanatory preamble to the proposed regulations, they are a straightforward application of a longstanding principle of tax law: When a taxpayer receives a valuable benefit in return for a donation to charity, that taxpayer can deduct only the net value of the donation as a charitable contribution. The rule applies that quid pro quo principle to state tax benefits provided to a donor in return for contributions. For instance, if a state grants a 50% credit and the taxpayer contributes $1,000, the allowable charitable contribution deduction may not exceed $500. The proposed regulations provide an exception for dollar-for-dollar state and local tax deductions as well as for tax credits of no more than 15% of the payment amount or of the fair market value of the property transferred. These guidelines would apply to both new and existing tax credit programs.
According to Treasury Secretary Steven Mnuchin: “Congress limited the deduction for state and local taxes that predominantly benefited high-income earners to help pay for major tax cuts for American families. The proposed rule will uphold that limitation by preventing attempts to convert tax payments into charitable contributions. We appreciate the value of state tax credit programs, particularly school choice initiatives, and we believe the proposed rule will have no impact on federal tax benefits for donations to school choice programs for about 99% of taxpayers compared to prior law.”
Due to a major increase in the standard deduction, the Treasury observed that 90% of taxpayers will not itemize under the new tax law; as such, the proposed regulations will not affect these taxpayers. The Treasury estimates that approximately 5% of taxpayers will itemize and have state and local income tax deductions above the SALT cap. Those taxpayers will generally see no change in the level of federal tax benefits available to them before the TCJA, but they will be unable to exploit the charitable deduction to avoid the SALT cap.
Further, the Treasury expects that only about 1% of taxpayers will see an effect on tax benefits for donations to school choice tax credit programs.
The proposed regulations would apply to amounts paid or property transferred by a taxpayer after August 27, 2018. As noted above, it is the view of the Treasury that rules contained in the proposed regulations are based on longstanding federal tax law principles.