Taxpayers may no longer be able to take a full federal tax deduction for a large swath of charitable donations. The Internal Revenue Service (IRS) recently proposed regulations governing the federal tax deduction for charitable donations in response to various states’ efforts to minimize the effect of the new $10,000 cap on the federal tax deduction for state and local taxes (SALT).
In 2017, Congress passed sweeping tax reform that included a $10,000 cap on the SALT deduction. This cap had a meaningful impact on taxpayers in states with relatively higher state property tax rates. In an effort to circumvent the effect of this cap, some states (New York, for example) pursued and/or passed legislation granting a rebate on any state property taxes owed in the form of a state tax credit if a taxpayer makes a donation to a designated state charitable fund. As a result, the taxpayer would be able to take a federal charitable tax deduction equal to the full amount of the donation/property tax bill and avoid having what would have otherwise been their SALT deduction for that payment be capped at $10,000.
Under the recently issued proposed regulation 112176-18, however, a taxpayer must reduce his or her charitable deduction by the amount of any state or local tax credits the taxpayer receives or expects to receive in exchange for making an eligible payment or donation. Thus, in the context of the SALT deduction, a taxpayer’s federal charitable deduction is limited to the excess of the donation made in lieu of paying their property taxes over the amount of the new state tax credit that these states are granting for this contribution.
It is no surprise that the IRS is attempting to curtail states’ efforts to bypass the new $10,000 cap on SALT deductions. The proposed regulations, however, do not narrowly address the SALT deduction issue. As currently proposed, these regulations would apply to any charitable deduction that has a parallel state tax credit associated with the charitable contribution.
The proposed regulations would have far-reaching consequences. For example, the amount of a state tax credit received by a taxpayer would reduce the amount of that taxpayer’s federal charitable tax deduction in many common situations, for example, a qualifying donation of a conservation easement or a charitable donation to a qualifying scholarship foundation or an organization eligible under the Virginia Neighborhood Assistance Program.
The argument set forth by the IRS in support of this position is that a federal charitable tax deduction is available only to the extent that there is no quid pro quo associated with a donation. That is, the IRS is applying the general rule that a donation is not tax deductible if the donor receives or expects to receive something of value in return for such a donation. The IRS now reasons that where a taxpayer simply receives a state tax credit in exchange for a charitable donation, without regard to whether the taxpayer takes a SALT deduction for the state credit, the amount of the state tax credit is a benefit received by the taxpayer that constitutes quid pro quo and reduces the deductible amount of the charitable contribution accordingly.
Though not specifically excepted, this reasoning leaves open questions with respect to those state tax credits to which a taxpayer is not automatically entitled simply by making an eligible donation. For example, a state tax credit in Virginia for the donation of a conservation easement is not a clear expectation merely because a taxpayer has made such a donation. A taxpayer is required to satisfy a myriad of other hurdles, including the Virginia Department of Taxation’s and Virginia Department of Conservation and Recreation’s acceptance of the various components of a taxpayer’s conservation easement donation application where applicable.
Significantly, the IRS has specifically announced that state tax credits received by businesses in exchange for business-related payments to charities or government entities will not reduce the amount of the taxpayer’s federal business expense deduction under Code § 162. It is important to note, however, that such an expense must still qualify as an “ordinary and necessary” business expense to qualify as a § 162 business expense.
Also, the proposed regulations are careful to delineate between state tax credits and state tax deductions. While the proposed regulations’ new rule would reduce the amount a taxpayer’s federal charitable tax deduction by the amount of any state tax credit, the same is not true of a state tax deduction. If a taxpayer receives a state tax deduction in exchange for a qualifying contribution (e.g., to a qualifying religious, charitable, or educational organization), the taxpayer may still claim a federal charitable tax deduction equal to the full amount of the contribution.
At present, these regulations are not final and the IRS is soliciting public comment until hearings are held on November 5, 2018.
Have questions? The Hirschler Tax Team is carefully monitoring this development, as well as numerous other rapidly evolving issues in tax law. Please contact a member of our Tax Team to learn more or to assess a specific deduction scenario.