Not-for-Profit Alert: Internal Revenue Service Issues Final Regulations on Charitable Contributions and State and Local Tax Deduction Limit Workarounds

June 19, 2019

By Israel Tannenbaum

The Internal Revenue Service (IRS) has finalized federal regulations regarding charitable contribution deductions where the taxpayer receives a related state or local tax credit. The IRS regulations were enacted to block attempts by various states to work around the $10,000 limit imposed by the Tax Cuts and Jobs Act (TCJA) of 2017 on the state and local tax (SALT) deduction. Under these IRS regulations, taxpayers are required to reduce their federal charitable contribution deductions by the amount of any state or local tax credits they receive or expect to receive in return.

Prior to this legislation, certain states attempted to try to get around the SALT deduction cap by passing legislation designed to convert state and local taxes to charitable contributions. Under the workarounds, taxpayers could donate to state and local charitable funds and receive tax credits against their state and local taxes. The intended benefit was for the taxpayers to then deduct the donations as charitable contributions on their federal returns, which aren’t capped.

The charitable funds, which many local governments set up to provide relief from the $10,000 cap, were particularly helpful to taxpayers in high-tax states. For example, New Jersey permitted localities to establish charitable funds and allows those localities to provide a property tax credit that is equal to 90% of the contributions to the charitable funds. New York authorized school and local districts to create charitable gifts trust funds, which allow taxpayers to make contributions for health care and education. Taxpayers who make any contributions to these funds may claim a tax credit equal to 85% of the donation amount for the tax year after the donation is made.

Under the final regulations, a taxpayer who makes payments or transfers property to an entity eligible to receive tax deductible contributions must reduce their charitable deduction by the amount of any state or local tax credit the taxpayer receives or expects to receive.

In the example provided by the IRS, if a state grants a 70% state tax credit and the taxpayer pays $1,000 to an eligible entity, the taxpayer receives a $700 state tax credit. The taxpayer must reduce the $1,000 contribution by the $700 state tax credit, leaving an allowable contribution deduction of $300 on the taxpayer’s federal income tax return.

The regulations provide exceptions for dollar-for-dollar state tax deductions and tax credits of no more than 15% of the payment amount or 15% of the fair market value of the property transferred. As a result, a taxpayer who makes a $1,000 contribution is not required to reduce the $1,000 federal charitable contribution deduction, if the state or local tax credit received or expected to be received is no more than $150.

The IRS also announced that it is publishing Notice 2019-12, which provides a safe harbor that allows an individual who itemizes deductions to treat, in certain circumstances, payments that are or will be disallowed as charitable contribution deductions under the final regulations as state or local taxes for federal income tax purposes. Eligible taxpayers may use the safe harbor to determine their SALT deduction on their 2018 federal return.

The IRS regulations are effective August 12, 2019 and apply to contributions made after August 27, 2018.

Mazars Insight:

The regulations would allow tax credits equal to just 15% of the contribution, making them an unappealing way to get around the SALT deduction cap.

This is a significant blow to nonprofit organizations, as these workarounds would have incentivized an increase in charitable giving and ultimately served as a great revenue generator for these organizations and a direct benefit for donors.

The new rule also has implications for pre-existing plans in other states, where residents have received tax credits for donating to school voucher programs, as these may also be considered “quid pro quo” under the newly issued regulations.

Please contact your Mazars USA LLP professional for additional information.

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