Final REGS Eliminate Benefit OF SALT Limitation Workarounds

Posted by Kim Chen on June 13th, 2019

T.D. 9864; Reg § 1.170A-1, Reg § 1.170A-13, Reg § 1.642(c)-3; IR 2018-172; IR 2019-109, 6/11/2019
IRS has issued final regs and an accompanying News Release which provide rules under which the amount otherwise deductible as a charitable contribution would generally be reduced by the amount of any state or local tax (SALT) credit received or expected to be received by the contributing taxpayer. The final regs contain no substantive changes to proposed regs that were issued in August 2018.
At the same time that IRS issued the final regs, it issued Notice 2019-12 that provides a safe harbor with respect to amounts disallowed as charitable contribution deductions under the final regs. For additional information regarding Notice 2019-12, see Safe harbor provision for payment to charity in return for SALT credit.
Background—charitable contribution deduction. Code Sec. 170(a)(1) generally allows an itemized deduction for any “charitable contribution” paid within the tax year. Code Sec. 170(c) defines “charitable contribution” as a “contribution or gift to or for the use of” any entity listed in that subsection. Code Sec. 170(c)(1) includes a contribution or gift to or for the use of a State, a possession of the U.S., or any political subdivision of the foregoing, but only if the contribution or gift is made exclusively for public purposes.
The Supreme Court has held that a charitable contribution must be a transfer of money or property without adequate consideration—that is, without the expectation of a quid pro quo. (American Bar Endowment (S Ct 1986) 58 AFTR 2d 86-5190) Reg. § 1.170A-1(h)(1) provides that no part of a payment that a taxpayer makes to or for the use of an organization described in Code Sec. 170(c) that is in consideration for goods or services is a contribution or gift within the meaning of Code Sec. 170(c) unless the taxpayer
i. Intends to make a payment in an amount that exceeds the fair market value of the goods or services; and
ii. Makes a payment in an amount that exceeds the fair market value of the goods or services.
Background—deduction for state and local taxes. For tax years beginning after 2017 and before 2026, the Tax Cuts and Jobs Act (TCJA; P.L. 115-97, 12/22/2017) amended Code Sec. 164(b)(6) to limit individual annual SALT deductions to a maximum of $10,000, with no carryover for taxes paid in excess of that amount. The SALT deduction limit doesn’t apply to property taxes paid in connection with a trade or business or in connection with the production of income. (Code Sec. 164(b)(6)) As a result of this change, many taxpayers will not get a full federal income tax deduction for their payments of state and local taxes.
While federal law limits the deduction for an individual’s charitable contributions, the limits are generally much higher than $10,000 (see Code Sec. 170(b)(1)), and there is a carryover of charitable contributions that exceed the charitable deduction limits. (Code Sec. 170(d)(1))
Background—state/local tax credit programs. In recent years, it has become increasingly common for states and localities to provide state or local tax credits in return for contributions by taxpayers to or for the use of certain entities listed in Code Sec. 170(c).
Chief Counsel Advice 201105010 observed that a payment to a state agency or charitable organization in return for a tax credit might be characterized as either a charitable contribution deductible under Code Sec. 170 or a payment of state tax possibly deductible under Code Sec. 164. The CCA advised that taxpayers may take a deduction under Code Sec. 170 for the full amount of a contribution made in return for a state tax credit, without subtracting the value of the credit received in return. According to the Preamble to the regs, the analysis in the CCA assumed that after the taxpayer applied the state or local tax credit to reduce the taxpayer’s state or local tax liability, the taxpayer would receive a smaller deduction for state and local taxes under Code Sec. 164.
In addition to the CCA, IRS Chief Counsel has taken the position in the Tax Court that the amount of a state or local tax credit that reduces a tax liability is not an accession to wealth under Code Sec. 61 or an amount realized for purposes of Code Sec. 1001, and the Tax Court has accepted this view. (Maines, (2015) 144 TC 123)
Almost immediately after the TCJA’s passage, certain state legislatures—specifically, those of high-tax states—began looking for ways to mitigate the effect of the new Code Sec. 164(b)(6) SALT deduction limit for their residents.
A number of states implemented workarounds to the deduction limit. For example, New York established new “charitable gifts trust funds” to which taxpayers can make deductible contributions and claim a tax credit equal to 85% of the donation. Similarly, New Jersey enacted legislation that permits localities to establish charitable funds to which taxpayers can contribute and receive a 90% New Jersey property tax credit.
Background—Notice 2018-54 and the 2018 proposed regs. In May 2018, IRS issued Notice 2018-54, 2018-24 IRB 750, in which it stated that, after reviewing the authorities under Code Sec. 170, e.g., American Bar Endowment, it was questioning the reasoning in the 2010 CCA and that it would be issuing proposed regs that would reflect its new line of reasoning.
In August 2018, IRS issued the proposed regs. (Preamble to Prop Reg REG-112176-18; see Proposed regs would eliminate benefit of SALT limitation workaround)
IRS issues final regs. IRS has now finalized the 2018 proposed regs without any substantive changes.
Thus, under the regs, a taxpayer who makes payments or transfers property to an entity eligible to receive tax deductible contributions has to reduce its charitable deduction by the amount of any state or local tax credit the taxpayer receives or expects to receive. (Reg § 1.170A-1(h)(3)(i)) For example, if a state grants a 70% state tax credit and the taxpayer pays $1,000 to an eligible entity, the taxpayer receives a $700 state tax credit. The taxpayer has to reduce the $1,000 contribution by the $700 state tax credit, leaving an allowable contribution deduction of $300 on the taxpayer’s federal income tax return. (Reg § 1.170A-1(h)(3)(vii), Example 1)
The rule of Reg § 1.170A-1(h)(3)(i) would not apply to dollar-for-dollar state tax deductions. (Reg § 1.170A-1(h)(3)(ii)(A)) IRS said that, although deductions could be considered quid pro quo benefits in the same manner as credits, it believes that sound policy considerations, as well as considerations of efficient tax administration, warrant making an exception to quid pro quo principles in the case of dollar-for-dollar state or local tax deductions. Because the benefit of a dollar-for-dollar deduction is limited to the taxpayer’s state and local marginal rate, the risk of deductions being used to circumvent Code Sec. 164(b)(6) is comparatively low. (TD 9864)
However, the regs state that, if the taxpayer receives or expects to receive a state or local tax deduction that exceeds the amount of the taxpayer’s payment or the fair market value of the property transferred, the taxpayer’s federal charitable contribution deduction has to be reduced. (Reg § 1.170A-1(h)(3)(ii)(B))
Observation. The reg does not spell out the amount by which the taxpayer’s charitable contribution deduction has to be reduced.
The rule of Reg § 1.170A-1(h)(3)(i) also does not apply for tax credits of no more than 15% of the cash paid, or of the fair market value of the property transferred, to the State. (Reg § 1.170A-1(h)(3)(vi)) Thus, for example, a taxpayer who makes a $1,000 contribution to an eligible entity is not required to reduce the $1,000 deduction on the taxpayer’s federal income tax return if the state or local tax credit received or expected to be received was no more than $150. (IR 2019-109)
IRS explains that this 15% de minimis rule provides consistent treatment for state or local tax deductions and state or local tax credits that provide a benefit that is generally equivalent to a deduction. It reflects that the combined value of a state and local tax deduction, that is the combined top marginal state and local tax rate, currently does not exceed 15%. (TD 9864)
The above reg rules also apply to payments made by trusts or decedents’ estates in determining the amount of their contribution deduction. (Reg § 1.642(c)-3(g)(1))
The rules in the regs are based on long-standing federal tax law principles and, thus, apply to taxpayers that participate in new state and local tax credit programs as well as taxpayers participating in programs that were in existence before the enactment of Code Sec. 164(b)(6). (TD 9864)
Observation. The regs effectively kill the state workarounds discussed above. That is, the function of the workarounds was to convert nondeductible state taxes into deductible charitable contributions; Reg § 1.170A-1(h)(3)(i) provides that the charitable deduction provided by the workaround is generally zero. And, the 15% rule in Reg § 1.170A-1(h)(3)(vi) does nothing to alleviate the death of the workarounds; making a $100 contribution to a state charity in order to reduce one’s state tax liability by $15 and get a $100 federal tax deduction for the contribution is not a money-saver for any taxpayer.
The preamble to the final regs also notes the following:
• Charitable contributions made to foreign organizations generally are not deductible for federal income tax purposes. (Code Sec. 170(c)(2)) In the limited situations where these deductions are allowed, taxpayers are treated as if they are making such contributions to entities that are organized in the United States, and accordingly, such contributions would be subject to the rules and regs under Code Sec. 170. As a result, if a taxpayer is seeking to deduct charitable contributions to foreign charities under Code Sec. 170, the quid pro quo principle set out in the regs would be equally applicable.
• Code Sec. 6115 generally requires donee disclosures in connection with quid pro quo contributions (as defined in Code Sec. 6115(b)), and specifically requires Code Sec. 170(c) organizations (but not Code Sec. 170(c)(1) entities) to provide donors with a good faith estimate of the value of goods or services they provide. In the general case contemplated by the regs, the charitable donee is not providing the credit to the donor; instead a state or local government is providing that credit. The preamble provides that, if a Code Sec. 170(c)(2) organization (a charitable contribution recipient that is a corporation, trust, foundation, etc.) is not providing the state or local tax credit to the donor, Code Sec. 6115 does not apply. Accordingly, there is no Code Sec. 6115 requirement for Code Sec. 170(c)(2) organizations to disclose information about a tax credit provided by a state or local government.
Effective dates. The regs under Code Sec. 170 apply to amounts paid or property transferred by a taxpayer after Aug. 27, 2018. (Reg § 1.170A-1(h)(3)(viii)) The regs under Code Sec. 642 apply to payments of gross income after Aug. 27, 2018. (Reg § 1.642(c)-3(g)(2))
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