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New Charitable Deduction Rules Could Impact Popular State Tax Credits

Since Congress passed the $10,000 limit and on state and local tax (SALT) deductions in late 2017, high-tax states have scrambled to create state programs that would allow taxpayers to circumvent this limit. These “SALT workarounds”, put in place by high-tax states such as New York and New Jersey, are designed to allow contributions to state-controlled charitable funds to satisfy state tax liability while providing a federal charitable contribution deduction at the same time.

To prevent this practice, the IRS has released proposed regulations that limit federal charitable deductions if a state tax credit is received in return. The problem is, in trying to stop the new SALT workarounds, the IRS drafted rules which also could reduce the tax benefits of contributing to popular state credit programs that were put in place before the SALT limit, such as the Georgia Rural Hospital Credit and the Georgia Private School Tax Credit. While the IRS and Treasury Department have been reassuring sponsors and contributors to these pre-existing credit programs of their continued benefits, the regulations as written apply to all state tax credit programs.

What’s in the Regs?

The proposed regulations say this: if a taxpayer makes a payment or transfers property to a nonprofit entity and the taxpayer receives “or expects to receive” a state or local tax credit in return, the taxpayer must reduce any federal charitable contribution deduction by the amount of the state credit. Specifically, the regulations propose the following rules:

  • Offset. Require that federal charitable deductions be reduced by the amount of state tax credits claimed for the same contribution.
  • De Minimis Exception. No offset is required if the state or local tax credit does not exceed 15% of the taxpayer’s payment or 15% of the fair market value of the property transferred by the taxpayer.
  • State Deductions. Taxpayers do not have to offset state tax deductions, only credits. However, if the taxpayer’s state deduction exceeds the amount of the taxpayer’s payment or the fair market value of the property transferred, the taxpayer’s federal charitable deduction must be reduced.

Possible Problems

Two types of taxpayers could lose tax benefits from contributing to state programs under the new regulations: taxpayers whose SALT deductions are below the $10,000 cap and C corporations that are not subject to the SALT cap. Taxpayers that do not hit the $10,000 SALT limit but contribute to state credit programs would have their SALT deduction reduced by the amount of the credit but would get no charitable contribution deduction instead, as under previous law. The IRS offers the following example:

If a taxpayer makes a $1,000 contribution to charity under the new rules, the entire $1,000 contribution is not deductible as a charitable contribution, but the deduction for state and local taxes  decreases by $1,000 because of the $1,000 state tax credit. Before the proposed rules, this same taxpayer would get the full $1,000 charitable contribution deduction, the $1,000 state tax credit, and a corresponding reduction in the federal SALT deduction.

Corporations deduct federal charitable contributions under the same section of the Code as individuals. Thus, they have been caught up in the new rules, perhaps unintentionally. Because regular C corporations are not subject to the $10,000 SALT limit, they lose the federal charitable deduction even though these contributions are not being made to get around any SALT deduction limit. Before the regulations, corporations were entitled to a SALT deduction, full state tax credits, and a full federal charitable deduction. A corporation’s state tax credit would reduce its deduction for state and local taxes paid, but the corporation would get a full charitable contribution deduction. Under the new rules, a corporation’s deduction for state and local taxes will be reduced as will its federal charitable deduction.

Declining State Credits

The regulations do not address the situation where a taxpayer declines a state credit and instead chooses to take a full federal charitable deduction. The IRS has specifically asked for comments on whether it should allow taxpayers to make a choice.

Treasury Touts Business Expense Deductions

Treasury Secretary Steve Mnuchin issued a statement assuring taxpayers that they can still take business expense deductions for contributions to charities. The problem is, existing law only allows business deductions for contributions if there is a business purpose and the business is getting something concrete in return, such as advertising. While Treasury’s release appears designed to head off criticism of the new regulations, substituting a business expense deduction for a charitable contribution deduction is not automatic. It may require a change in state laws to allow benefits, such as advertising and sponsorships, to flow back to businesses that contribute to state programs.

Comments Pouring In

The Treasury Department and the IRS have requested comments on the proposed regulations and received over 1,400 comments as of mid-September. Most of those commenting are associated with state scholarship and land conservation programs and ask Treasury to exempt their programs or grandfather in programs that existed before 2018, when the SALT deduction limit took effect. Others are requesting that the IRS use a “facts and circumstances test” to assess the true nature and public policy function of tax-exempt organizations.

Comments are due by October 11, 2018, and the IRS is holding a public hearing on the rules on November 5, 2018. If you want to comment, you can send your comment electronically via the Federal eRulemaking Portal. Make sure to indicate the regulation project number, REG-112176-18, on your comment.

Conclusion

Treasury has a problem with trying to enforce the $10,000 SALT limitation but still allow charitable contribution deductions for popular state programs. With all of the negative comments, Treasury may need to modify the final regulations to carve out these programs. However, it is not going to be easy to write regulations that allow full deductions for some state credit programs and not others.

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