New IRS Regs May Quash Popular SALT Cap Workaround
This week, the Internal Revenue Service published its final regulations on Internal Revenue Code Sections 162, 164 and 170 addressing attempts to end-run the 2017 Tax Cuts and Jobs Act's cap on state and local tax, or SALT, deductions.
Prior to the TCJA, Section 164 authorized taxpayers to deduct the full amount of their state and local taxes — mostly property taxes and income taxes — subject to the limitation on itemized deductions. In December 2017, Congress enacted the TCJA, including revised Section 164(b)(6), which limits the aggregate deduction of these taxes to $10,000 — less if not filing a joint return.
This little provision in a juggernaut piece of tax legislation quickly became a political lightning rod and largely overshadowed the massive and complex TCJA tax package. Several states with high state and local tax burdens cried foul. There were accusations that the burden of the $10,000 cap fell disproportionately on blue states. Efforts to undermine or eliminate the $10,000 limitation followed.
The states of New York, New Jersey, Connecticut and Maryland filed suit in the U.S. District Court for the Southern District of New York to declare the cap unconstitutional. They pointed out that a deduction for state and local property taxes and state income taxes has existed in the tax laws since the enactment of the first federal income tax during the Civil War.
They further charged that the cap was "intentionally targeted at a subset of politically disfavored states." After the states lost at the district court, they appealed to the U.S. Court of Appeals for the Second Circuit where the case is pending.
Additional responses to the $10,000 limitation included measures to circumvent new Section 164(b)(6). Most notably, several states including New York and New Jersey enacted a workaround designed to convert state and local taxes into charitable deductions. Essentially, these workaround programs offered taxpayers a mechanism to donate to state and local government-run entities that qualified as charitable entities under federal law and used the funds to pay for government services that otherwise would be funded through taxes.
In exchange, the contributors would receive tax credits to apply against their state and local tax liabilities. Thus, the taxpayers' cash out of pocket would be redirected from the amount they would otherwise pay in state and local taxes into the government-run fund. But the kicker for the plan to work as intended was that the contributors would then claim an Internal Revenue Code Section 170 deduction on their federal income tax returns, which are not subject to the $10,000 cap.
Could you really get a charitable deduction on your federal return when you received a substantial benefit from the contribution in the form of a credit against your state and local tax liabilities?
The Law on Charitable Deductions
Section 170(a)(1) generally allows an itemized deduction for any charitable contribution paid within the taxable year. Section 170(c) defines "charitable contribution" as a "contribution or gift to or for the use of" any entity listed in that subsection. Section 170(c)(1) includes a contribution or gift to or for the use of a state, a possession of the U.S., or any political subdivision of the foregoing, but only if the contribution or gift is made exclusively for public purposes.
More important to the charitable deduction workaround is how the term "charitable contribution" has been construed.
The U.S. Supreme Court, in U.S. v. American Bar Endowment, held that the "sine qua non of a charitable contribution is a transfer of money or property without adequate consideration." A "payment of money generally cannot constitute a charitable contribution if the contributor expects a substantial benefit in return." In other words, was the transaction in which the payment was involved structured as a quid pro quo exchange, as several courts have posed the question?
In light of these judicial interpretations, why wouldn't a contribution in exchange for state tax credits constitute a quid pro quo and thus fail the definition of a charitable contribution for purposes of Section 170?
Well, in 2010, the IRS issued a chief counsel advice, or CCA, in which the IRS Chief Counsel's Office advised that a payment to a state agency or charitable organization in return for a tax credit might be characterized as either a charitable contribution deductible under Section 170 or a payment of state tax possibly deductible under Section 164.
The 2010 CCA concluded that taxpayers may take a deduction under Section 170 for the full amount of a contribution made in return for a state tax credit, without subtracting the value of the credit received in return. Taxpayers also would not realize income based on the benefit from their reduced state tax liability.
At first blush, this 2010 CCA seems to support the feasibility of the charitable deduction workarounds. Note, however, that CCAs generally are not binding on the IRS. Furthermore, at the time of this CCA and on the CCA's facts, it made no practical difference if an amount was treated as a state and local tax deduction under Section 164 or as a charitable contribution deduction under Section 170. Both were uncapped itemized deductions.
The TCJA's limit on state and local tax deductions eliminated the tax parity between Section 164 and Section 170 deductions, and thus it now matters. If payments of state and local taxes are allowed to masquerade as charitable deductions, state and local tax credit programs could circumvent the $10,000 limitation in Section 164(b)(6).
Does the Workaround Work?
According to the IRS, the charitable deduction workaround unequivocally does not work. In the final regulations, the IRS reinforces its position that charitable deductions under Section 170 are not available when there is a quid pro quo.
The IRS views the receipt of state tax credits in exchange for a donation as a quid pro quo. This according to the IRS disqualifies the donation from being considered charitable. The final regulations further apply the quid pro quo principle irrespective of whether a donee or a third party provides the quid pro quo.
But for taxpayers that had unwittingly attempted the workaround, there are potentially worse things than just losing a charitable deduction. Since these taxpayers did not, in form, pay the state and local taxes for which they received credits, do the contributions even count toward the $10,000 cap?
If made by a business, are they prevented from claiming a Section 162 ordinary and necessary expense? Are these taxpayers subject to a whipsaw — no charitable deduction and no deduction for paying state and local taxes?
An A for Effort
In the final regulations, the IRS effectively said "no, but nice try."
They provided relief to individual taxpayers who made contributions to government-funded Section 170(c) organizations by confirming that, to the extent the payment into the state and local charitable fund reduces state and local taxes, the taxpayer may treat the donations as taxes paid and include the amounts in the Section 164 deduction for state and local taxes, and further that any excess may be eligible for a Section 170 charitable deduction. Moreover, unused tax credits may be carried forward in accordance with state or local law.
The final regulations also provided safe harbors for certain entities. C corporations that made workaround payments to Section 170(c) organizations, expecting to receive state or local tax credits for such payments, are generally able to treat such payments as ordinary and necessary business expenses under Section 162.
An almost identical provision has been added for specified pass-through entities, as defined in Treasury Regulation Section 1.162-15(a)(3)(ii); however, specified pass-through entities do not receive Section 162 treatment for payments made in anticipation of credit towards state or local income taxes.
For example, a C corporation that expects a $1,000 credit toward its state corporate income tax liability as a result of a payment of $1,000 to a Section 170(c) organization may treat the $1,000 payment as an ordinary and necessary business expense under Section 162. But a specified pass-through entity that expects a $1,000 credit toward its owners' income taxes as a result of a $1,000 payment to a Section 170(c) organization will not receive Section 162 treatment for its payment.
The final regulations also clean up certain guidance in tension with these final regulations.
Section 162(b) states: "No deduction is allowable under Section 162(a) for a contribution or gift by an individual or a corporation if any part thereof is deductible under Section 170." The IRS had previously issued regulations that interpreted this provision as disallowing the deduction if any part of the contribution was deductible under Section 170.
The final regulations clarify that this limitation only applies to contributions or gifts made to Section 170(c) organizations. Taxpayers are not precluded from establishing that the payments were directly related to their trade or business and within Section 162.
A payment to a Section 170(c) organization that is directly related to the taxpayer's trade or business and made with reasonable expectation of a financial return corresponding to the amount of the payment may be considered a trade or business expense under Section 162(a), rather than a charitable deduction under Section 170.
For instance, if an entity makes a $1,000 donation to a church for a half-page advertisement and expects increased sales as a result of the advertisement, the entity may treat the $1,000 as a trade or business expense under Section 162. The fact that the payment was made to a charitable institution does not automatically determine the characterization of the payment.
Finally, it is notable that the final regulations do not address SALT limitation workaround strategies other than the charitable deduction scheme. States such as Connecticut and New Jersey, for example, have enacted legislation that permit owners of pass-through entities to pay state and local taxes at the entity level. The recently released U.S. Department of the Treasury regulations do not directly address or undermine these strategies.
The final regulations likely shut down attempts to end-run the TCJA's cap on state and local tax deductions by converting state and local taxes into federally deductible charitable contributions. But these regulations may not be the last word. There remains an effort to invalidate the statutory cap altogether on constitutional grounds, as well as other strategies to end-run the cap. One also should not rule out possible attempts to invalidate the latest regulations or to outright repeal the cap if the upcoming election cycle results in a change in administration.
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