August 29, 2018 Proposed regulations would affect all state and local tax credit programs, not just those recently enacted in response to the federal $10,000 SALT deduction cap On August 23, 2018, the Treasury and IRS published much-anticipated proposed regulations (REG-112176-18) on the deductibility for federal income tax purposes of charitable contributions for which a taxpayer received a state or local tax (SALT) benefit (to be codified under Prop. Treas. Reg. Sections1 1.170A-1 and 1.642-XX) (the Proposed Regulations). The Proposed Regulations would limit the deductibility for federal income tax purposes of charitable contribution deductions under Section 170 when a taxpayer receives, or expects to receive, a corresponding SALT benefit, such as a credit against state or local personal income or property tax liabilities. The guidance also proposes changes to Treasury Regulations under Section 642(c) to apply similar rules to charitable contributions made by trusts and estates receiving similar SALT benefits. The Proposed Regulations respond to recently enacted state laws authorizing the creation of state-sponsored charities to which taxpayers could contribute and receive a credit against their personal income or property tax liabilities. These state "workarounds" are broadly viewed as an attempt to assist taxpayers in circumventing the $10,000 SALT deduction cap recently enacted under the 2017 Tax Cuts and Jobs Act, P.L. 115-97 (TCJA). The Proposed Regulations would apply broadly and, if finalized in their current form, would likely affect other long-standing state and local programs involving charitable contributions and SALT credits. Although the new workarounds were the impetus for the Proposed Regulations, the Proposed Regulations would go much further and eliminate the federal income tax benefit corporations receive from charitable contributions coupled with SALT credits, even though the $10,000 SALT deduction cap does not apply to them. The Proposed Regulations would apply to contributions made after August 27, 2018. A public hearing is scheduled for November 5, 2018. All requests to speak at the hearing and outline topics must be submitted to the IRS by October 11, 2018 (45 days after the Proposed Regulations are published in the Federal Register). Background Charitable contributions are generally deductible for federal income tax purposes under Section 170(a)(1). The definition of a "charitable contribution" includes a contribution or gift to or for the use of a state, a US possession or any political subdivision of either, as long as the contribution or gift is made exclusively for public purposes (Section 170(c)(1)). Itemized deductions are also permitted under Section 164 for the payment of certain taxes, including: (1) state, local, and foreign real property taxes; (2) state and local personal property taxes; and (3) foreign, income, war profits, and excess profits taxes. As amended by the TCJA, Section 164(b)(6) limits to $10,000 ($5,000 for married individuals filing separately), for tax years beginning from January 1, 2017, through December 31, 2025, the deduction that an individual may claim for the aggregate amount of SALT paid during each calendar year. Based on long-standing case law (United States v. American Bar Endowment, 477 U.S. 105 (1986)), a donation cannot be considered a charitable contribution if the contributor expects to receive a substantial benefit in return, and the value of any benefit that is received (e.g., the value of a T-shirt when contributing to Public Radio) must be subtracted from the amount of the charitable deduction claimed on the individual's federal income tax return. SALT credit programs enacted in many states provide credits against state tax liabilities to taxpayers that make contributions to or for the use of certain Section 170(c) entities (e.g., Battleship New Jersey Fund). As these SALT credit programs became more numerous, the IRS Chief Counsel's Office issued several Chief Counsel Advice memoranda (CCAs) over the years addressing whether receipt of SALT credits under the programs constituted "quid pro quo" benefits that would reduce the amount of a taxpayer's charitable deduction under Section 170(a). Although some of these CCAs, published in 2002 and 2004, recommended issuing formal guidance, the Proposed Regulations represent the first published guidance on "whether a taxpayer's expectation or receipt of a [SALT] credit may reduce a taxpayer's charitable contribution deduction under Section 170," according to the Proposed Regulations' preamble. SALT deduction cap under Section 164 Before enactment of the TCJA, a taxpayer generally could claim an unlimited itemized deduction under Section 164 for payment of state and local taxes. Further, allowing a charitable contribution deduction for a transfer in exchange for a SALT credit generally would not affect the taxpayer's federal income tax liability because the increased Section 170 deduction would be offset by the decreased Section 164 deduction. With the new $10,000 SALT deduction cap in place under newly enacted Section 164(b)(6), however, treating a transfer under a SALT credit program as a charitable contribution could reduce the taxpayer's federal income tax liability. Therefore, according to the preamble to the Proposed Regulations, SALT credit programs "now give taxpayers a potential means to circumvent the $10,000 limitation in [S]ection 164(b)(6) by substituting an increased charitable contribution deduction for a disallowed [SALT] deduction." With a handful of state legislatures adopting (and many others considering adopting) new SALT credit programs to enable their residents to work around the $10,000 SALT deduction cap, the Treasury and IRS announced (Notice 2018-54) on May 23, 2018, that proposed regulations were imminent (see Tax Alert 2018-1119). The new Proposed Regulations differ somewhat from those contemplated in Notice 2018-54, in that rules in the "[P]roposed [R]egulations, and the analysis underlying the [P]roposed [R]egulations, are intended to apply to transfers pursuant to [SALT] credit programs established under the recent state legislation as well as to transfers pursuant to [SALT] credit programs that [existed] before the enactment of [S]ection 164(b)(6)," the preamble states. Proposed regulations The Proposed Regulations are based on the IRS's belief that a taxpayer's receipt, or expected receipt, of a SALT credit or similar benefit in return for a payment or other transfer to a Section 170(c) entity constitutes a "quid pro quo," potentially precluding the taxpayer from claiming a charitable contribution deduction for federal income tax purposes. Therefore, the Proposed Regulations would require an otherwise deductible charitable contribution deduction to generally "be reduced by the amount of the [SALT] credit received or expected to be received." The preamble cites policy considerations for taking this approach, explaining that, without the new Proposed Regulations: (1) the federal government would otherwise incur significant revenue losses; (2) the $10,000 cap on SALT deductions, as adopted by Congress in Section 164(b)(6), could be obviated by SALT credit programs in numerous states; (3) taxpayers would be encouraged and enabled to characterize SALT payments as fully deductible charitable contributions for federal income tax purposes while using the same payments to meet their SALT liabilities; and (4) Congress's intent in adopting Section 170 would be undermined. Under the Proposed Regulations, a taxpayer that (1) makes a payment or transfers property to or for the use of a Section 170(c) entity and (2) receives or expects to receive a SALT credit in return must reduce the charitable contribution deduction he or she claims to reflect the quid pro quo received. The Proposed Regulations would, however, treat SALT deductions differently than SALT credits, noting that "the risk of deductions being used to circumvent [S]ection 164(b)(6) is comparatively low" because "the benefit of a dollar-for-dollar deduction is limited to the taxpayer's state and local marginal rate." Therefore, the Proposed Regulations would allow taxpayers to claim dollar-for-dollar SALT deductions without reducing the corresponding charitable deductions. If, however, a taxpayer receives, or expects to receive, a larger SALT deduction than the amount of the taxpayer's payment or the fair market value (FMV) of property transferred, the charitable contribution deduction must be reduced. The Proposed Regulations also provide a de minimis exception, allowing a taxpayer to claim a SALT credit that does not exceed 15% of the taxpayer's payment or 15% of the FMV of property transferred and the entire corresponding charitable deduction. Three examples in the Proposed Regulations illustrate these situations: 1. Individual A makes a $1,000 contribution to a Section 170(c) entity and receives, or expects to receive, a SALT credit based on 70% of the payment amount. A's charitable contribution deduction must be reduced by $700 ($1,000 x 70%), regardless of whether A is able to claim the SALT credit in that year. 2. Individual B transfers a painting with a FMV of $100,000 to a Section 170(c) entity, and receives or expects to receive a SALT credit equal to 10% of the painting's FMV. Because the amount of the SALT credit received or expected to be received does not exceed 15% of the painting's FMV, the amount of B's charitable contribution deduction is not reduced. 3. Individual C makes a $1,000 payment to a Section 170(c) entity and is entitled under state law to receive a SALT deduction equal to the $1,000 payment. C is not required to reduce his or her charitable contribution deduction under Section 170(a) on account of the SALT deduction. This result differs because this is a SALT deduction, not a SALT credit. The Proposed Regulations do not address whether a taxpayer may decline to receive a SALT credit by taking some sort of affirmative action when making a payment or transferring property, although the IRS is requesting "comments regarding a rule that would allow taxpayers to decline [SALT] credits and receive full deductions for charitable contributions under [S]ection 170." Because trusts and estates may claim deductions for charitable contributions under Section 642(c), the Proposed Regulations would amend Treas. Reg. Section 1.642(c)-3 to provide that the proposed rules under Prop. Treas. Reg. Section 1.170A-1(h)(3) apply to payments made by a trust or estate in determining its charitable contribution deduction under Section 642(c). Implications According to the Government's press release, the Proposed Regulations are designed to clarify the relationship between SALT credits and the federal income tax rules for charitable contribution deductions. The Treasury is of the opinion that the proposed rule is "a straightforward application of a [long-standing] principle of tax law." If the conclusion was so straightforward, however, why did so many courts, and the Chief Counsel's office, conclude that receiving a federal or state tax benefit for a charitable contribution does not affect the amount of the charitable deduction? (See McLennan v. United States, 23 Cl. Ct. 99 (1991), subsequent proceedings, 24 Cl. Ct. 102, 106 n.8 (1991), aff'd, 994 F.2d 839 (Fed. Cir. 1993); Skripak v. Commissioner, 84 T.C. 285, 319 (1985); Allen v. Commissioner, 92 T.C. 1, 7 (1989), aff'd, 925 F.2d 348 (9th Cir. 1991).) As noted in the preamble, this round of the Proposed Regulations is not the final version, and the IRS requests comments on at least six collateral federal income tax considerations that stem from these SALT credit arrangements. This argues that these arrangements are not exactly "straightforward." Regardless of the clarity or ambiguity of the long-standing law, the Proposed Regulations were aimed at the rules created in certain states to help individual taxpayers after enactment of the TJCA's $10,000 SALT deduction cap. But in doing so, they did much more: — The Proposed Regulations would apply the quid-pro-quo rule of American Bar Endowment to any donation to a Section 170(c) organization that could generate a tax credit. The approach would affect recent plans like New York's, which generated a tax credit for a contribution to the state, but would also affect donations to exempt organizations not connected to the state. For example, the Proposed Regulations could apply to a situation in which: (1) a taxpayer donates a conservation easement on his/her farm to a Section 501(c)(3) land conservation organization; and (2) the state grants him/her a tax credit. — Although the preamble cited the individual deduction limitation imposed by TCJA as a primary purpose for the regulations, the Proposed Regulations would also eliminate any benefit to corporate taxpayers, which are not subject to any SALT deduction limitation. — The Proposed Regulations do not discriminate between "red" state plans or "blue" state plans, nor between TCJA-inspired plans or plans that have been in place for decades. The Proposed Regulations would eviscerate them all equally. Over 50% of states have some sort of contribution-based tax credit plan that will be negatively affected. — Finally, the Proposed Regulations do not phase out when the $10,000 SALT deduction limitation phases out after December 31, 2025. Thus, regardless of the fate of the $10,000 SALT deduction limitation, the Government intends these regulations to have a much longer life. Lastly, the Proposed Regulations only focus on limiting the perceived benefits from state- or local-sponsored charitable deduction programs in connection with the $10,000 SALT deduction limitation. They do not address any of the other types of "SALT workarounds" that states have enacted to help their taxpayers mitigate the impact of the $10,000 SALT deduction limitation, such as Connecticut's enactment of a pass-through entity tax for which taxpayers can obtain a tax credit against their own tax obligations (see Tax Alert 2018-1142) or New York's employer compensation expense tax (see Tax Alert 2018-0724), an employer elective entity-level payroll tax for which employees may claim a credit against their New York personal income tax liabilities. The use of a quid-pro-quo approach in the Proposed Regulations suggests that the Treasury and IRS may apply a similar standard to these other types of SALT deduction limit workarounds — although, in our view, the differences between the various programs are so great and the regulatory territory so new that developing any sort of a regulatory response to these types of programs could be problematic. It is likely that state legislatures will continue to try to find ways to circumvent the $10,000 SALT deduction limitation. The question is how long that will take and what additional responses the Government will come up with to counteract them. ———————————————
——————————————— 1 All "Section" references are to the relevant section or sections of the Internal Revenue Code of 1986, as amended (the Code), or to the Treasury Regulations (Treas. Regs.) promulgated by the Treasury under the Code, unless stated otherwise. | |||||||||||||
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