Final SALT Cap Regulations Require Reductions to Charitable Deductions

• Treasury and IRS have issued final regulations that require reductions to charitable contributions where donors receive a state tax credit in exchange for the charitable contribution made.
• A safe harbor allows individuals who itemize deductions on their federal tax return to treat payments made in exchange for state tax credits that are disallowed under the final regulations as payments of state or local taxes for federal income tax purposes, subject to the $10,000 cap.

Treasury and IRS have issued final regulations under which amounts otherwise deductible as charitable contributions are generally reduced by the amount of any state and local tax (SALT) credit received or expected to be received by a contributing taxpayer. The final regulations apply retroactively to contributions made after August 27, 2018 (the date previous proposed regulations were released).

According to the final regulations, a federal charitable deduction is only allowed to the extent a contribution to a charitable organization exceeds the state tax credit generated by the contribution. However, the final regulations provide exceptions for dollar-for-dollar state tax deductions and for tax credits of no more than 15% of the payment amount or of the fair market value of the property transferred. Notice 2019-12, issued simultaneously with the final regulations, also provides a potential safe harbor for individuals who itemize deductions to restore the lost state and local tax deduction, subject to the $10,000 cap.

Background

The Tax Cuts and Jobs Act (TCJA) capped at $10,000 the amount of state and local tax payments that filers could deduct from their federal tax returns. States such as California, Connecticut, New Jersey, New York, and Oregon responded by attempting to create workarounds designed to help residents circumvent the $10,000 limit on deductions for state and local taxes.

Under such plans residents could, instead of paying state property tax, choose instead to donate to a state-created charitable fund. A resident could deduct the amount of the donation on their federal tax return and also receive a state tax credit. Both of these benefits would help mitigate the effect of the lower federal deduction for state and local taxes.

Impact of Final Regulations

The final regulations thwart potential state workarounds by limiting a taxpayer’s charitable deduction to the difference between the state tax credit they receive and the amount of their donation. For example, a taxpayer who makes a $1,000 charitable donation to pay property taxes and receives a $700 state tax credit would be limited to no more than a $300 charitable deduction on their federal tax return.

To be deductible, a charitable contribution must be a voluntary transfer of money or property without receiving or expecting to receive a benefit in return for the contribution, IRS explained in its notice of adoption. A taxpayer who makes a payment or transfers property to a charitable organization in return for a state or local tax credit is receiving a benefit. As a result, the taxpayer must reduce their charitable deduction by the amount of the credit, the notice of adoption stated.

The final regulations provide exceptions for dollar-for-dollar state tax deductions and for tax credits of no more than 15% of the amount transferred. For example, a taxpayer who receives a state tax deduction of $1,000 for a contribution of $1,000 is not required to reduce the federal income tax deduction to take into account the state tax deduction. Additionally, a taxpayer who makes a $1,000 contribution is not required to reduce the $1,000 federal income tax deduction if the state or local tax credit received or expected to be received is no more than $150.

Safe Harbor

In response to comments received on the proposed regulations, Treasury and IRS also issued Notice 2019-12 in conjunction with the final regulations. Notice 2019-12 provides a safe harbor that, subject to certain limitations, allows individuals who itemize deductions to treat payments made in exchange for tax credits as payments of state or local taxes for federal income tax purposes. Eligible taxpayers can use the safe harbor to determine their SALT deduction for their 2018 federal tax return and can file an amended return if they have already filed.

Revenue Procedure 2019-12 was issued late last year and continues to provide a safe harbor for businesses that make charitable contributions. Under the safe harbor, a C corporation can generally treat a contribution for which it receives a credit as an ordinary and necessary business expense. A pass-through entity may treat a contribution as an ordinary and necessary business expense to the extent the tax credit reduces a state and local tax other than an income tax (such as a property tax) which is deducted by the entity and not passed through to the individual owners.

The Takeaway

The final regulations directly target the efforts by New York and other states to use charitable donations as a means of circumventing the SALT deduction limit. However, other ways states have devised to mitigate the cap on the SALT deduction, such as allowing pass-through entities to take greater federal deductions or utilizing a payroll tax system that would allow employees to claim a personal income tax credit for state income tax liability, were not addressed by the final regulations.