As part of the Tax Cuts and Jobs Act, which was passed in December 2017, the itemized deduction for state and local taxes (SALT) is capped at $10,000 ($5,000 for married taxpayers filing separately) for tax years beginning after December 31, 2017, and before January 1, 2026. This amount includes state and local real and personal property tax and the greater of income or sales taxes paid. Amounts paid or accrued in connection with a trade or business aren’t subject to this limitation. In an attempt to circumvent this new cap, several states responded by introducing and enacting various state income, payroll and real property tax credits in exchange for amounts paid to qualifying charitable organizations.
For example, a taxpayer could contribute $10,000 to a charitable entity listed in Internal Revenue Code Section 170(c) offering a 60 percent state income tax credit and receive a $6,000 tax credit for state income tax purposes. In addition, if the taxpayer itemized, he would receive a charitable contribution deduction of $10,000.
On August 23, the IRS and U.S. Department of the Treasury released proposed guidance that aims to prevent this strategy for new and pre-existing state tax credit incentive programs. The proposed regulations provide that, for charitable contributions made after August 27, 2018, in which a taxpayer receives a state tax credit, a federal deduction will be allowed only to the extent the contribution exceeds the amount of the tax credit received. Using the same facts as the example above, the taxpayer would be required to reduce the previously allowed $10,000 federal charitable contribution deduction to $4,000 (reduced by the $6,000 state income tax credit received).
This rule is based on the application of the quid pro quo principle, which only allows taxpayers to deduct the net value of charitable contributions when a valuable benefit is received from the contribution. However, the proposed regulations do offer a de minimis rule, which allows a full federal deduction for charitable contributions if the state tax credit doesn’t exceed 15 percent of the charitable contribution. The proposed regulations also don’t require a reduction in the federal charitable contribution deduction if the state only provides a dollar-for-dollar deduction instead of a credit and the deduction doesn’t exceed the amount of the charitable contribution.
As previously mentioned, the proposed regulations apply to charitable contributions made after August 27, 2018. It’s uncertain if contributions made prior to this date will be subject to the proposed rules. A public hearing on the proposed regulations is scheduled for November 5 in Washington, D.C. Given the contentious nature of this topic, it’s likely the IRS will receive numerous comment letters and requests to speak at the hearing, so we’ll be following this issue closely.
Contact Kori or your trusted BKD tax advisor for more information.