As part of the Tax Cuts and Jobs Act (TJCA), 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 for real and personal property tax in connection with a trade or business aren’t subject to this limitation.
States’ Responses to SALT Cap
In an attempt to circumvent this new cap, Connecticut, New Jersey and New York responded by introducing and enacting various state income, payroll and/or real property tax credits in exchange for amounts paid to qualifying charitable organizations under Internal Revenue Code (IRC) Section 170(c).
To illustrate this strategy, a taxpayer could contribute $10,000 to a state-specified fund offering a 75 percent state income tax credit and receive a $7,500 tax credit for state income tax purposes. In addition, if the taxpayer itemized, he or she would receive a federal charitable contribution deduction of $10,000 provided the fund qualifies under IRC §170(c). This strategy, in effect, shifts the deduction from a SALT deduction to a charitable deduction to avoid the $10,000 cap.
Connecticut also enacted an entity-level tax on pass-through entities, whereby the pass-through entities are allowed a federal deduction for the state tax paid and the equity owners receive a credit against their individual state income tax liability. Arkansas and New York are considering similar measures.
In addition to the above changes in state law, Connecticut, Maryland, New Jersey and New York filed suit against the federal government over the SALT deduction cap in mid-July. The suit asserts “the new cap effectively eviscerates the SALT deduction, overturning more than 150 years of precedent” and “seeks to compel certain States to reduce their public spending.” This case is still pending in federal court and may not be decided prior to December 31, 2018.
IRS & Treasury Target States’ Responses
On August 23, the IRS and U.S. Department of the Treasury (Treasury) released proposed guidance that aims to prevent this strategy for new and preexisting 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 in the example above, the taxpayer would be required to reduce the previously allowed $10,000 federal charitable contribution deduction to $2,500 (reduced by the $7,500 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.
In a September 5 news release, the IRS clarified the proposed regulations don’t affect the availability of a business expense deduction under IRC §162. Thus, if a taxpayer makes a payment to a charitable organization described in IRC §170(c) as an ordinary and necessary business expense under IRC §162, e.g., for advertising or promotion, and receives a tax credit, the proposed regulations don’t apply.
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 Forrest, Kori, Amy or your trusted BKD tax advisor for more information.