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The IRS has finalized regulations (TD 9864) under IRC Section 170, largely in keeping with proposed regulations issued in August 2018, to provide rules on the deductibility for federal income tax purposes of charitable contributions for which a taxpayer receives, or expects to receive, a state or local tax (SALT) benefit. Like the proposed regulations, the final regulations also apply similar rules under IRC Section 642(c) to payments made by a trust or decedent's estate. (For more on the proposed regulations, see Tax Alert 2018-1714.).

Concurrently with the final regulations, the IRS issued Notice 2019-12, which contains a safe harbor that generally allows an individual who itemizes deductions to treat would-be charitable contribution deductions that are disallowed under the final regulations as state or local taxes for federal income tax purposes. The notice allows taxpayers to employ the safe harbor to determine their SALT deduction for the 2018 tax year, either on their original or an amended return.

Background

The regulations package represents the Service's response 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 enacted under the Tax Cuts and Jobs Act of 2017 (TCJA). Although aimed at the SALT deduction cap workarounds, the final regulations apply not just to state and local programs established after the TCJA was enacted, but to all state and local programs involving charitable contributions and SALT credits, regardless of when a particular program was established.

The IRS Chief Counsel's Office issued several Chief Counsel Advice memoranda (CCAs) 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 IRC Section 170(a). For example, in CCA 201105010 (the 2010 CCA) the IRS Chief Counsel advised that, under certain circumstances, a taxpayer may claim a IRC Section 170 charitable deduction for the full amount of the contribution made in exchange for a state tax credit.

Notice 2019-12

Notice 2019-12 provides a safe harbor that allows an individual who itemizes deductions on his tax return and makes a payment to an entity described in IRC Section 170(c) in exchange for a SALT credit to treat the portion of the payment that may not be claimed as a charitable contribution deduction under IRC Section 170 instead as a SALT payment under IRC Section 164. In Notice 2019-12, the IRS requests comments "for purposes of incorporating the safe harbor into anticipated proposed regulations under [IRC] Section 164."

Final regulations

Following publication of the proposed regulations in August 2018, the IRS received more than 7,700 comment letters and 25 requests to speak at a public hearing. The Preamble states that approximately 70% of the comments were favorable toward the proposed regulations — ultimately the final regulations make very few changes. The most significant new development resides in the safe harbor established in Notice 2019-12.

The 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 IRC Section 170(c) entity constitutes a "quid pro quo," potentially precluding the taxpayer from claiming a charitable contribution deduction for federal income tax purposes. The Preamble highlights numerous categories of comments provided in response to the proposed regulations, including the following:

Tax consequences of treating tax credits as benefits. The IRS and Treasury agreed with comments noting that the proposed regulations failed to fully address the tax consequences of treating tax credits as quid pro quo benefits and issued Notice 2019-12 as a result. The Notice provides a safe harbor under IRC Section 164 for individuals who itemize deductions and make a payment to a IRC Section 170(c) entity in return for a SALT credit.

Quid pro quo benefit from third party. Commenters argued that a tax credit from a state or local government should not reduce a deduction for a payment to a IRC Section 170(c)(2) organization. As support, they noted that a quid pro quo benefit received from a third party should not reduce a taxpayer's charitable contribution deduction.

In response to these comments, the IRS and Treasury plan to propose additional regulations "setting forth a general rule for all benefits received or expected to be received from third parties, not just tax credits," the Preamble states. Further, the Preamble notes that, "under the most logical and consistent application of existing law, a charitable contribution deduction is reduced by any consideration a donor receives or expects to receive, regardless of whether the donee is the party from whom consideration is received or expected to be received."

Conservation easement contributions. The Preamble attributes "a large number of comments" to issues involving conservation easement contributions. The IRS found one comment worth further consideration — specifically that conservation easement donors who are able (in some states) to sell their credit should get basis in the credit equal to the amount by which the charitable contribution deduction is reduced. The IRS and Treasury plan to consider the issue for future guidance.

Taxpayers at or below the $10K IRC Section 164(b)(6) limit. In response to commenters recommending that the IRS revise how the proposed regulations applied to taxpayers with SALT deductions at or below $10K, the IRS and Treasury provided a safe harbor in Notice 2019-12, the Preamble explains.

Application of IRC Section 162 for business taxpayers. Some comments asserted that the proposed regulations essentially favored business taxpayers, who could still claim deductions for donations to IRC Section 170(c) entities as business expenses under IRC Section 162. Because the regulations require both a business and individual taxpayer to reduce the charitable contribution deduction by the amount of any return benefit the donor receives or expects to receive, the Preamble notes, the commenters' concerns stem not from disparate treatment under IRC Section 170, but rather from IRC Sections 162 and 164, including the application of the $10K SALT limitation. Recognizing "that the final regulations may raise additional questions regarding the application of [IRC Sections 162 and 164] to business entities that make payments to [IRC Section] 170(c) entities and that receive or expect to receive state or local tax credits in return for such payments," the IRS issued Notice 2019-12 along with the final regulations, the Preamble notes.

Valuing and substantiating the credits. Responding to concern that taxpayers and donees could have difficulty determining the value of a SALT credit, the IRS states in the Preamble that, "if the credit does not have a clear maximum credit allowable, a taxpayer's good faith estimate of the value will satisfy the rules of the final regulations."

Concerns over reduced charitable giving. The Preamble discounts concerns expressed by a "large number of commenters" that the regulations would cause a decline in charitable giving, affecting education programs, health care organizations, and conservation easements in particular. Treasury and the IRS "recognize the importance of the federal charitable contribution deduction, as well as state tax credit programs, in encouraging charitable giving," and have concluded that, taken together, Notice 2019-12 and the regulations "will not alter the charitable giving incentives for the overwhelming majority of taxpayers." Asserting that Notice 2019-12 will mitigate the final regulations' effect on SALT credit programs that incentivize giving to all IRC Section 170(c) entities — including those involving educational scholarship programs, child care and public health — the Preamble contends that "the impact on taxpayers' choices will be small."

The Preamble also lists certain points on which the IRS requests comments, including how a taxpayer may decline SALT credits in certain situations.

Implications

If the bickering between state and federal governments were a football game, we'd be at end of the first quarter with the federal government in the lead. Early last summer, the IRS threw down the gauntlet on the charitable contribution work arounds, then followed through with wide-reaching proposed regulations. The IRS stuck with its game plan and finalized the regulations in virtually the same form as they were proposed. Then the whistle blew.

As the clock starts in the second quarter, the IRS has told taxpayers to keep an eye out for additional regulations on the same subject later this year. The forthcoming regulations will, apparently, adopt the principles of the newly issued Notice 2019-12, with modifications as needed to accomplish its intended goal, as well as formalizing the treatment of credit program for business taxpayers that the IRS addressed in Revenue Procedure. 2019-12. The big question is whether these proposed regulations will take on the area that was intentionally avoided in Revenue Procedure 2019-12, namely the treatment of income tax credit transactions by pass-through entities and individuals.

Lurking in the background through all of this is the fate of the alternative tax systems created by states such as New York, Connecticut, Wisconsin and Oklahoma — which could be the third quarter of the SALT game. These alternative tax systems devised by the states, although seemingly independent from the regulations, all stem from the same tension between the states and federal government that gave rise to the regulations.

The final quarter will be unlike a traditional football game — this is when the players on the bench, namely individual taxpayers, come onto the field of play. The field of play, in this instance, is where they interact with the IRS in exam, appeals and through the courts. Until now, they have been spectators. But, unlike the state legislatures and the IRS that jockeyed for dominance in the first three quarters, these individual players have real dollars at stake. This fourth quarter, like all good final quarters, could go right down to the line, and possibly even into overtime (i.e., when pending controversies continue past the point in time when the $10,000 limitation on SALT deductions expires).

Consider summer 2019 a commercial break between quarters. Get some snacks, drinks and provisions, because we're settling in for another interesting few quarters of high-stakes gamesmanship.

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