On June 11, 2019 the Treasury Department and IRS released final regulations implementing the IRS position that taxpayers may not take a full federal charitable deduction for charitable donations that may also result in the taxpayer receiving state or local tax credits or benefits. The final regulations confirmed the IRS position will be applied to all charitable donations occurring on or after August 27, 2018.
The Internal Revenue Service (IRS) proposed regulations in August of 2018 to reduce federal charitable deductions in response to New York and some other high-tax states’ efforts to avoid the $10,000 cap on the federal deduction for state and local taxes (SALT) paid under IRC section 164. Some states have passed legislation granting a state tax credit or rebate if a taxpayer makes a “donation” to a designated state charitable fund. For example, a taxpayer making a $30,000 “donation” to a designated state charitable fund would qualify for a $30,000 state tax credit or rebate. As a result, the taxpayer would have been able to take a federal charitable deduction for the full amount of the “donation” ($30,000) and avoid the $10,000 SALT deduction cap under Internal Revenue Code (IRC) Section 164. Rather than simply disallowing such “donations” as charitable deductions, in the proposed regulations the IRS took the opportunity to attack all charitable donations that may also result in state or local tax credits or benefits under separate state or local incentives. The proposed regulations announced the IRS position that a taxpayer’s federal charitable deduction is reduced dollar-for-dollar by the amount of any state or local tax credits or benefits the taxpayer may receive or expects to receive in connection with the charitable donation. Thus, a taxpayer’s net federal charitable deduction is limited to the excess of the federal deduction over the amount of any state or local tax credit or benefit that the taxpayer receives or expects to receive.
The IRS received a high volume of reaction and criticism of the proposed regulation. Nonetheless, the recently released final regulation reaffirm the IRS position that that a taxpayer’s federal charitable deduction must be reduced dollar-for-dollar by the amount of any state or local tax credits or benefits the taxpayer may receive or expects to receive in connection with the charitable donation.
Examples of legitimate donations that are targeted by this IRS position include a qualifying conservation donation or a charitable donation to a qualifying scholarship foundation or an organization eligible under the Virginia Neighborhood Assistance Program. For example, a Virginia donor donating a conservation easement valued at $1,000,000, who may also apply for state preservation tax credits of $400,000, would have to take a reduced federal charitable deduction of $600,000, not $1,000,000.
The IRS position leaves open questions with respect to state and local tax credits and benefits to which a taxpayer is not automatically entitled simply by making an eligible donation. For example, a state tax credit in Virginia for the donation of a conservation easement is not a clear expectation merely because a taxpayer has made such a donation. A taxpayer is required to satisfy a number of state requirements in applying for a state tax credit, and the Virginia Department of Taxation’s and Virginia Department of Conservation and Recreation’s must review and accept the various components of a taxpayer’s conservation easement donation application (including the application’s explanation of how the donation complies with the state program and the appraisal accompanying the application) before a state credit may be issued.
The final regulations also continue to distinguish between state tax credits and state tax deductions, noting that a taxpayer receiving a state tax deduction in connection with a charitable donation is not subject to the same reduction of federal charitable deduction, to the extent that the state tax deduction received does not exceed the amount of the charitable donation.
The final regulations also continue a de minimis exception for state tax credits issued that do not exceed fifteen percent (15%) of the contribution amount. If the state tax credits are within this de minimis amount, the federal charitable deduction will not be reduced. However, this exception is a cliff exception, meaning if the state tax credit exceeds 15% of the contribution amount, even by $1, the federal charitable contribution is reduced by the entire amount of the state tax credit.
The IRS has specifically announced that state tax credits received by businesses in exchange for business-related payments to charities or government entities will not reduce the amount of the taxpayer’s federal business expense deduction under IRC Section 162, meaning such expenses remain fully-deductible under IRC Section 162. It is important to note, however, that such an expense must still qualify as an “ordinary and necessary” business expense to qualify as a IRC Section 162 business expense.
Also on June 11, 2019 the Treasury Department and the IRS issued Notice 2019-12, 2019-27 I.R.B., providing a new safe harbor for individuals who itemize deductions, make charitable contributions qualifying for charitable deductions, and also realize or may realize a state or local tax credit or benefit in connection with such contribution. The safe harbor provides that the individual may treat the reduced portion of such charitable deduction as a deemed payment of state or local tax for purposes of IRC Section 164, to the extent the individual applies the state or local tax credit to offset the individual’s state or local tax liability. Therefore, this deemed payment amount can be added to other state and local tax payments and treated as a payment of state or local tax, giving rise to a federal deduction under IRC Section 164 (though such deduction is subject to the $10,000 cap under Code Section 164).
In the final regulations the IRS also announced it is studying whether a taxpayer will have basis in the state or local tax credits received equal to the amount of reduction of the taxpayer’s federal charitable deduction in connection with such state or local tax credits.
Have questions? The Hirschler Tax Team is carefully monitoring this development, as well as numerous other rapidly evolving issues in tax law. Please contact a member of our Tax Team to learn more or to assess a specific deduction scenario.