You can’t always get what you want. But if you try sometimes, you find. You get what you need.
Those may be words crooned by the Rolling Stones, but the sentiment was echoed by the Internal Revenue Service (IRS). The IRS has released proposed regulations intended to address the workaround proposed by a handful of states in response to the Tax Cuts and Jobs Act (TCJA), and it’s not precisely what taxpayers wanted.
Under the TCJA, the amount that taxpayers may claim on Schedule A for all state and local sales, income, and property taxes together may not exceed $10,000, or $5,000 for married taxpayers filing separately.
Previously, there was no specific limitations on the amount of taxes you could claim on your Schedule A, though some taxpayers faced reduced itemized deductions due to the alternative minimum tax (more on the AMT here) and Pease limitations (more on those here). The TCJA changed that, slapping a cap on SALT deductions effective for the 2018 tax year, causing some taxpayers to cry foul.
In response, some states suggested a workaround. Proposals have included variations on state and local charitable funds or trusts which would accept payments from taxpayers in satisfaction of state and local tax liabilities. The idea, of course, is that those payments would then be re-characterized as fully deductible charitable contributions for federal income tax purposes. Those schemes already exist in some states to allow taxpayers a break on private school tuition since there’s no pure federal income tax deduction for private school tuition; you can read more about private school tuition here.
Hoping to put the kibosh on a rush to circumvent the new law, the IRS issued a warning in spring, “The proposed regulations will make clear that the requirements of the Internal Revenue Code, informed by substance-over-form principles, govern the federal income tax treatment of such transfers.” The tax world took a collective breath – and waited. (You can read more about the IRS notice here.)
As it turns out, the guidance wasn’t as bad as feared. I know, that’s not completely reassuring, but the fear was that any step towards limiting the deduction would have the unintended consequence of wiping out the benefit of existing state credit programs. The IRS has generally allowed those, even issuing Chief Counsel Advice memoranda (CCA) to that effect (it’s worth noting that CCAs are made public but do not carry the same weight as official guidance).
However, the new limits on SALT deductions have made it clear that the IRS needed to reexamine this question. So they did. Here’s what they determined.
(You can read the proposed regulations as a PDF here.)
Whenever you make a charitable gift, if you receive anything in return, the fair market value of what you receive must not be included in your total charitable deduction. It makes sense that you can’t claim a deduction for the entire amount because you received something of value in return.
The classic example is the pledge tote bag. When you call into a charity like public radio or public television, you often do so because you’ve been incentivized to call in exchange for a gift. Your $500 donation may net you a charitable deduction AND a nifty tote bag. Let’s assume the tote bag is worth $100 because it’s filled with Hamilton CDs. The charitable contribution is $400, not $500, because you’ve received $100 worth of stuff in return for your gift. Got it?
It’s a well-established principle referred to as quid pro quo. It was even featured in my popular “Taxes From A to Z” series last year (click here).
The IRS assumes that taxpayers who are contributing to these workarounds are expecting something in return. When you make receive or expect to receive a state or local tax credit in return for your contribution, the IRS takes the position that the receipt of this tax benefit is a quid pro quo – and you don’t get the take the full value of the deduction. The proposed regulations call for the amount otherwise deductible as a charitable contribution to be reduced by the amount of the state or local tax credit received or expected. The IRS says that is consistent with existing rules.
Here’s a quick example. Let’s say you write a check for $20,000 as a charitable donation in lieu of paying your property taxes. Let’s also assume you receive a state tax credit worth $18,000 state tax credit for that donation. For federal income tax purposes, you could only deduct $2,000 on a federal tax bill as a charitable deduction – the quid pro quo of $18,000 is disregarded.
There are some more rules, because… tax.
Specifically, the proposed regulations allow you to disregard dollar-for-dollar state or local tax deductions. However, if you receive or expect to receive a state or local tax deduction that exceeds the amount of your payment or the fair market value of the property transferred, your charitable contribution deduction must be reduced.
But what if you made the contribution and then elected to decline the state or local credit? What then? The IRS hasn’t worked out that bit just yet.
There’s also a de minimis provision (you may recall that the Latin phrase de minimis translates roughly to “of little importance” and lawyers love Latin). It allows you to disregard the value of a state or local tax credit if the credit doesn’t exceed 15% of your payment or 15% of the fair market value of the transferred property. Why 15%? According to the IRS, the combined value of a state and local tax deduction (the combined top marginal state and local tax rate) currently does not exceed 15%. Therefore, a state or local tax credit that does not exceed 15% will not reduce your federal deduction for a charitable contribution.
Oh, and one more thing: The IRS proposes that these regulations apply to contributions after August 27, 2018. That gives you a few days if you’re feeling lucky to try and reduce your 2018 tax bill – though that could be a tricky proposition. You’ll want to consult with your tax professional before making a big move.
In July, four states (Connecticut, Maryland, New Jersey, and New York) filed a lawsuit in federal court to strike down the cap on SALT deductions under the new tax law. That lawsuit is pending.