The IRS late last week released proposed regulations that require, in most cases, taxpayers to reduce their federal charitable deduction by the amount of a state or local tax credit received. This was intended largely to stop states from enacting work-arounds to the limitation on state and local tax deductions put in place by recent tax legislation, but its broad drafting captures much more—including credits like Colorado’s Enterprise Zone Contribution Credit and Child Care Contribution Credit.
Recap of Tax Law Changes. The Tax Cut and Jobs Act established a cap of $10,000 for state and local tax (“SALT”) deductions under Section 164 of the Tax Code, but did not cap the amount that can be deducted as a charitable contribution under Section 170. As such, states with higher income tax rates—whose residents would feel the SALT limit more strongly—began putting together proposals to allow taxpayers to direct part of their payments to funds or separate charitable organizations. The thinking was that this would allow taxpayers to bifurcate and deduct their full payments between the SALT and charitable deductions. However, these proposals caused concern at the IRS with respect to whether such payments were truly charitable contributions eligible for deduction.
Background on State Tax Credits. While tax credit ideas were recently stimulated by the changes under the Act, state charitable credits are not new. In Colorado, two longstanding ones are the following:
- Enterprise Zone Contribution Credit, which offers a 25 percent credit (up to a maximum of $100,000 in each tax year) for contributions to designated projects in order to spur economic development.
- Child Care Contribution Credit, which offers a 50 percent credit (up to a maximum of $100,000 in each tax year) for contributions to promote childcare in Colorado.
Charitable organizations in Colorado have long relied on the credits as a fundraising bonus, because in the past the amount taken as a state credit reduced state tax liability dollar-for-dollar, and didn’t detract from the amount deductible as a federal charitable contribution—though it would reduce the amount deducted as a SALT deduction (discussed below).
More than 30 states have put in place a variety of similar tax credits, meant to encourage donations or spur activities in certain areas. Arizona, for example, has credits available for donations to private school tuition organizations and qualifying foster care organizations, among others.
Proposed Regulations. The IRS has proposed regulations under Section 170 that will affect most state tax credit programs, including those that have been in place for years and that are not tied to changes in SALT deductibility. Essentially, the IRS is treating the receipt of the state tax credit as a quid pro quo benefit that will reduce the amount of the charitable deduction.
In general, under the quid pro quo doctrine, a taxpayer cannot take a deduction for a payment for which the taxpayer receives an equal value of goods or services. However, payments can (and often do) contain both a donative component that can be deducted, and a quid pro quo component that cannot. This is the doctrine that limits an individual attending a charity gala from deducting the full value of a ticket—typically there is a quid pro quo component for food and drinks associated with the event, but the balance of any amount paid over that value can be deducted. The proposed rules would apply the doctrine with the following effect:
Example: A Colorado taxpayer who makes a $100,000 contribution that qualifies for the Enterprise Zone Contribution Tax Credit, and receives a $25,000 credit, will only be able to deduct $75,000 as a federal charitable contribution.
This is a departure from previous IRS guidance, such as Chief Counsel Advice Memorandum 201105010, which did not require a reduction in federal charitable deduction for amount taken as a state tax credit. The IRS justifies this change in treatment by pointing out that under prior law, federal income taxation would generally be unaffected by allowing a taxpayer to deduct an amount for which they’d received a state tax credit, because that credit would reduce SALT and their related deduction under Section 164. But with the $10,000 SALT cap in place, taxpayers with SALT over the $10,000 limitation that take a federal charitable contribution will no longer have a corresponding reduction in their SALT deduction amount—because they were limited from deducting it in the first place. However, there is not any carveout for taxpayers who are under the $10,000 SALT limitation, who would in fact have their deduction under Section 164 reduced by the amount taken as a tax credit but still would be limited from deducting their full charitable contribution. In fact, the examples contained in the description of the proposed regulations note this increase in tax liability on page 21.
It should be noted that this new treatment does not extend to payments for which a taxpayer receives a dollar-for-dollar state charitable deduction. The IRS’ reasoning here is that the value of a deduction is limited to a taxpayer’s state and local marginal rates, so there is less chance of gaming the system to circumvent the SALT limitation. In addition, there is a de minimis exception for credits that do not exceed 15 percent of the taxpayer’s contribution.
Our Two Cents. This broad change in approach regarding state tax credits will have a huge effect on many charitable organizations nationwide. And this comes on top of another hit to the charitable sector—an increase in the amount of the standard deduction, which means fewer taxpayers will itemize going forward and may reduce charitable giving as a result. The IRS has set a hearing for November 5, and will accept comments on the proposed regulations. We encourage charities and donors to make their voices heard on this.
Send submissions to Internal Revenue Service, CC:PA:LPD:PR (REG-112176-18) Room 5203, P.O. Box 7604, Ben Franklin Station, Washington, DC 20044.
Submissions may be hand-delivered Monday through Friday between the hours of 8:00
a.m. and 4:00 p.m. to CC:PA:LPD:PR (REG-112176-18), Courier’s Desk, 1111
Constitution Avenue, N.W., Washington, DC 20224, or sent electronically, via the
Federal eRulemaking Portal at www.regulations.gov (indicate IRS and REG-112176-
18). The public hearing will be held in the IRS Auditorium, Internal Revenue Building,
1111 Constitution Avenue, N.W., Washington, DC 20224.
The IRS could foreclose the recent maneuvering on SALT, without affecting longstanding credits like Colorado’s, by focusing not on quid pro quo (in opposition to prior guidance) but on the voluntary nature of payments. A longstanding tenet of charitable donations and deductibility is that a payment must be voluntary; a transfer that is required by law lacks the essential characteristic of a gift. If a taxpayer has a SALT bill of $15,000 and pays the $10,000 cap to the state and the remaining $5,000 to a charitable fund or entity set up by the state for public purposes, it isn’t a voluntary payment—the taxpayer owes that $5,000 no matter what. The taxpayer is just changing where it is sent. In contrast, a payment to a charitable organization for which a tax credit can be taken and that is not at all tied to SALT liability is purely voluntary.