Final Treasury Regulations Clarify Rules for Charitable Contributions and State and Local Tax Credits
On June 11, 2019, the IRS issued TD 9864, the long-awaited final regulations and guidance for federal income tax treatment of charitable donations made by taxpayers in exchange for state and local tax (“SALT”) credits. The final rules are effective for payments made on or after August 27, 2018, and solidify the IRS’ position announced last year. These rules were intentionally designed to address so called SALT workarounds: charitable funds created by high-tax states to help their residents who may be hurt by the $10,000 limit on SALT deductions introduced by the Tax Cuts and Jobs Act of 2017. Although the attention has been placed on SALT workarounds, this new guidance will also apply to situations where taxpayers make donations to educational or qualified scholarship funds, neighborhood assistance funds, and rural hospital funds in exchange for SALT credits.
Under the final regulations, taxpayers can continue to make a qualifying donation to an IRC §170(c) charitable organization and in return receive a tax credit to offset a state or local income tax, property tax, or similar tax. The new regulations apply to limit the amount of such donation a taxpayer may claim as a charitable contribution deduction. A taxpayer is generally required to reduce the amount of the donation by the amount of SALT credit received. The remaining balance, if any, may be deducted as a charitable contribution on the federal income tax return. The rules limiting a contribution deduction do not apply when the SALT credits are no more than 15% of the cash contribution or 15% of the fair market value (“FMV”) of the property contributed.
At the same time as the final regulations were released, the IRS released Notice 2019-12 to provide a safe harbor under IRC §164 for taxpayers who itemize deductions and have a disallowed charitable contribution deduction under the final regulations. In this instance, the disallowed deduction (i.e., SALT credit) can be treated as a payment of state taxes for purposes of IRC §164 in the tax year that the SALT credit is utilized to offset the taxpayer’s tax liability. The safe harbor only applies to cash payments and does not apply to property donations.
The final regulations and safe harbor notice are best understood in the following examples. Assume in each example the taxpayer is an individual who itemizes deductions for federal tax purposes.
Example 1: Taxpayer A makes a cash gift of $10,000 to a scholarship organization that provides donors with a state income tax credit equal to 80% of the contribution. Taxpayer A’s state income tax credit is equal to $8,000. Under the final regulations, taxpayer A may claim a charitable contribution deduction of $2,000. ($10,000 donation – $8,000 credit received = $2,000 contribution deduction)
Under the safe harbor, if taxpayer A uses all of the $8,000 credit to offset a state or local tax, then taxpayer A may treat the $8,000 disallowed charitable deduction as a state tax payment deductible as an itemized deduction on Form 1040, Schedule A — subject to the $10,000 annual limitation.
Example 2: Assume taxpayer A’s state income tax liability is only $5,000. Taxpayer A uses $5,000 of the SALT credit to offset the tax liability and carries forward the remaining credit of $3,000 to next year. Under the safe harbor, only $5,000 can be reported in the current year as a state income tax payment on Schedule A. The remaining $3,000 carried forward may be reported as a state tax payment in the next year the credit is used.
Example 3: Assume taxpayer B makes a land donation (with a FMV of $100,000) to a qualifying organization and receives a state conservation income tax credit of 15% of the land FMV or $15,000. Under the final regulations, taxpayer B’s credit does not exceed 15% of the donation and therefore it is not limited. Taxpayer B may report a federal charitable contribution of $100,000 (assuming no other limitations).
The final regulations were designed to put a stop to certain funds created to avoid the $10,000 annual SALT deduction limit. But, other funds that advance good benefits in our communities are also impacted. It may still be appropriate to consider contributions to these funds even now that the regulations and Notice 2019-12 safe harbor are in place. Charitable funds that provide SALT credits and other programs granting SALT credits allow taxpayers to direct the use of their tax dollars to organizations they prefer, convert nondeductible charitable contributions into potentially deductible state taxes for federal tax purposes, and in some cases, pay state income taxes with cheaper dollars.
Taxpayers should consult with their advisors regarding any contributions made in 2018 and beyond that may be impacted by the new regulations.