January 10, 2020 IRS issues proposed regulations on treatment of payments to charities in return for consideration, and impact of federal cap on the SALT deduction The IRS has issued proposed regulations (REG-107431-19) amending regulations under IRC Sections 162, 164 and 170 affecting limitations on the deductibility of charitable contributions for which the taxpayer receives some other benefit, most notably a state or local tax credit (2019 proposed regulations). In addition to updating the current regulations to reflect changes in the law brought about by the Tax Cuts and Jobs Act (P.L. 115-97) (TCJA), the 2019 proposed regulations: (1) amend safe harbors under IRC Section 162 to provide certainty with respect to the treatment of payments business entities make to entities described in IRC Section 170(c); and (2) provide a new safe harbor under IRC Section 164 for payments made to an IRC Section 170(c) entity by individuals who itemize deductions and receive or expect to receive a credit against their state or local tax liabilities as a result. A public hearing has been scheduled for February 20, 2020. The IRS asks that written comments and outlines of topics to be discussed at the hearing be submitted by Friday, January 31, 2020. Background An itemized deduction is generally allowed under IRC Section 170(a)(1) for any charitable contribution paid within a tax year. Taxpayers can qualify for such a deduction if the charitable contributions are made to a state, a US possession, a political subdivision or the District of Columbia (see IRC Section 170(c)(1)), in addition to certain corporations, trusts, community chests, funds or foundations organized and operated exclusively for religious, charitable, scientific, literary or educational purposes, or to foster national or international amateur sports competition, or to prevent cruelty to children or animals (see IRC Section 170(c)(2)). A taxpayer that (1) transfers to an organization described in IRC Section 170(c) property with a direct relationship to the taxpayer's trade or business and (2) reasonably expects to receive a commensurate financial return, may be entitled to deduct such an amount as a trade or business expense deduction under IRC Section 162 instead of as a charitable contribution deduction (see Prop. Treas. Reg. Section 1.170A1(c)(5)). A business generally may deduct its ordinary and necessary business expenses paid or incurred during a tax year under IRC Section 162(a), but no business expense deduction is permitted for a contribution or gift that would qualify as a charitable deduction under IRC Section 170 if it were not for the percentage limitations, dollar limitations, or requirements regarding the time of payment under IRC Section 170 (Prop. Treas. Reg. Section 1.162-15(a)(1)). Prop. Treas. Reg. Section 1.162-15(a)(2) clarifies that the limitations of IRC Section 162(b) and Prop. Treas. Reg. Section 1.162-15(a)(1) only apply to payments that are contributions or gifts to organizations described in IRC Section 170. IRC Section 164 permits taxpayers to claim deductions for the payment of certain taxes, including: (1) state, local and foreign real property taxes; (2) state and local personal property taxes; (3) state, local and foreign income, war profits and excess profits taxes; and (4) taxes not described in 1, 2 or 3 that are paid or accrued within the applicable tax year in carrying on a trade or business or an activity described in IRC Section 212. Enactment of the TCJA in December 2017 added IRC Section 164(b)(6) to provide that, in the case of an individual, deductions for foreign real property taxes are not allowable under IRC Section 164(a)(1) and the deduction for aggregated state and local tax (SALT) (e.g., income tax, sales tax, real property tax, personal property tax) paid during the tax year is capped at $10,000 (or $5,000 for married couples filing separately) for tax years beginning in calendar years 2018–2025 (SALT deduction limit). Importantly, the SALT deduction limit does not apply to foreign taxes under IRC Section 164(a)(3) or any taxes under IRC Section 164(a)(1) and (2) paid or accrued in carrying on a trade or business activity. Various state and local governments have created programs aimed at helping taxpayers mitigate the effect of the SALT deduction limit (including SALT credit programs under which taxpayers who contribute to IRC Section 170(c) entities created and promoted by state and local governments receive a corresponding tax credit against their respective state and local tax liabilities in return). Attempting to quell the success and proliferation of these "workaround" programs, the IRS and Treasury have issued several pieces of formal and informal guidance. In June 2018, Treasury issued Notice 2019-54 which announced its intention to propose regulations addressing how IRC Sections 164 and 170 apply to taxpayers who make contributions to IRC Section 170(c) entities under SALT credit programs (see Tax Alert 2018-1119). In August 2018, new regulations (REG-112176-18; see Tax Alert 2018-1714) were proposed, amending existing regulations under IRC Section 170 to generally provide that if a taxpayer makes a payment or transfers property to or for the use of an IRC Section 170(c) entity and receives or expects to receive a SALT credit in return, the taxpayer must reduce its charitable contribution deduction by the amount of the tax credit, because it is considered a return benefit (2018 proposed regulations). This reasoning in the 2018 proposed regulations was based on the concept of quid pro quo, as articulated in United States v. American Bar Endowment, 477 U.S. 105 (1986). More than 7,700 comment letters were submitted in response to the 2018 proposed regulations; a public hearing was held in November 2018 at which 25 commenters requested to speak. Taking the comments into consideration, the IRS issued final regulations (TD 9864; Tax Alert 2019-1150) in June 2019 that largely retained the rules described in the 2018 proposed regulations — including the rule that if a taxpayer makes a payment or transfers property to an IRC Section 170(c) entity in return for a SALT credit the tax credit is a return benefit that reduces the taxpayer's charitable contribution deduction. The IRS stated that comments received on Notice 2018-54 and the 2018 proposed regulations raised "ancillary issues" that were not addressed in the final regulations but have since been addressed in other guidance. These issues included: (1) how a business's payments to an IRC Section 170(c) entity will be treated; (2) how payments would be treated if made by individuals with SALT liabilities at or below the SALT deduction limit; and (3) how the quid pro quo principle applies under IRC Section 170 to benefits that the donor receives or expects to receive from someone other than the donee. Despite having provided safe harbors addressing issues 1 and 2 described in the preceding sentence (i.e., Revenue Procedure 2019-12 and Notice 2019-12; see Tax Alert 2019-1150), the IRS and Treasury decided to include the safe harbors in the 2019 proposed regulations and request comments. In addition, the final regulations reserved issue 3, above, for future regulations, and it is being addressed in the 2019 proposed regulations. 2019 proposed regulations Payments by businesses in exchange for SALT credits In response to questions received after issuing Notice 2018-54, asking whether businesses that made payments to IRC Section 170(c) entities under SALT credit programs could deduct the payments as business expenses under IRC Section 162, the IRS published a frequently asked questions list in September 2018 confirming that a business expense deduction was permissible as long as the payment is made with a business purpose (see Tax Alert 2018-1778). Questions continued, however, regarding whether the business purpose requirement is fulfilled if a contribution results in a tax credit. In December 2018, the IRS published a safe harbor in Revenue Procedure 2019-12, providing that a C corporation or specified passthrough entity that makes a payment to, or for the use of, an IRC Section 170(c) entity in return for or anticipation of receiving a SALT credit may treat the portion of the payment equal to the credit received as an ordinary and necessary business expense under IRC Section 162. Incorporating these safe harbors in the 2019 proposed regulations and requesting comments on them, the IRS and Treasury "specifically request comments on whether the safe harbors should be expanded to apply to an individual who is carrying on a trade or business or an activity described in [IRC S]ection 212." Under the 2019 proposed regulations, if a taxpayer's payment or transfer has a direct relationship to its trade or business and is made with a reasonable expectation of receiving commensurate financial return, the payment or transfer to an IRC Section 170(c) entity may be claimed as a business expense under IRC Section 162 instead of as a charitable contribution under IRC Section 170. Payments by individuals in exchange for SALT credits In response to the 2018 proposed regulations, some commenters had expressed concern that these regulations could treat individuals who receive SALT credits in return for their payments unfairly. Notice 2019-12 outlined future regulations aimed at this concern and requested comments. The preamble to the 2019 proposed regulations explains that the IRS continues to study several issues raised by these comments, including whether the IRS should: (1) either track the effects of the safe harbor by requiring taxpayers to disclose SALT credits on Form 1040, Schedule A, or obtain this information directly from the states; and (2) provide guidance addressing the treatment of SALT credits for federal income tax purposes when they are sold or expire. Viewing Notice 2019-12 as providing "a fair, reasonable, and legally sound basis for the safe harbor for individual taxpayers, and that the safe harbor should be added to the regulations under [IRC S]ection 164," the IRS has essentially incorporated the notice into the 2019 proposed regulations. Specifically, the 2019 proposed regulations: (1) provide a safe harbor for individuals who make a payment to, or for the use of, an IRC Section 170(c) entity in return for a SALT credit; and (2) propose adding a section to the regulations under IRC Section 170 to cross reference the safe harbor proposed under Prop. Treas. Reg. Section 1.164-3(j). The safe harbor allows an individual who itemizes deductions and makes a payment to an IRC Section 172(c) entity in exchange for a SALT credit to treat as a SALT payment for IRC Section 164 purposes the portion of the payment for which a charitable contribution deduction is disallowed under Prop. Treas. Reg. Section 1.170A-1(h)(3). The safe harbor may be applied in the tax year in which the payment is made but only to the extent that the SALT credit is applied under applicable state or local law to offset the taxpayer's SALT liability for that tax year or the preceding tax year. Unused credit may be carried forward and treated as a SALT payment under IRC Section 164. The preamble to the 2019 proposed regulations expressly states that they "are not intended to permit a taxpayer to avoid the limitations of [IRC S]ection 164(b)(6)" or to permit deductions of the same payments under more than one provision of the IRC. Consideration provided by a party other than the donee Prop. Treas. Reg. Section 1.170A-1(h)(1) states that no part of a payment that a taxpayer makes to, or for the use of, an IRC Section 170(c) entity that is in consideration for goods or services constitutes a charitable contribution or gift unless the taxpayer (1) intends to make a payment that exceeds the fair market value (FMV) of the goods or services, and (2) actually makes a payment that exceeds that FMV. "In consideration of" is defined for these purposes in Prop. Treas. Reg. Section 1.170A-1(h)(3)(iii) as having the same meaning as set out in Prop. Treas. Reg. Section 1.170A-13(f)(6), except that the donee organization does not need to be the entity providing the SALT credit. Some commenters interpreted this as suggesting that consideration provided by a third party is disregarded in calculating the charitable contribution deduction and that the proposed regulations (Prop. Treas. Reg. Section 1.170A-1(h)(3)(iii)) contained an exception solely for SALT credits provided by third parties. The final regulations reserved this issue to be addressed in future regulations, saying the IRS and Treasury intended to modify the IRC Section 170 regulations to clarify "that the quid pro quo principle applies regardless of whether the party providing the quid pro quo principle is the donee." Citing American Bar Endowment and noting that other courts have held that "a taxpayer's expectation of significant financial returns demonstrates a lack of charitable intent," Treasury stated that the expectation of benefits, as opposed to the source of those benefits, is what matters. In keeping with this principle, the 2019 proposed regulations provide that a taxpayer will be treated as receiving goods or services in consideration for the taxpayer's payment or transfer to an IRC Section 170(c) entity if, when the payment or transfer occurred, the taxpayer receives or expects to receive goods or services in return. The IRS and Treasury request comments on whether it would be helpful to provide guidance on how to substantiate and report quid pro quo benefits that are provided by third parties, including state governments. In addition, the 2019 proposed regulations:
Proposed applicability dates The IRS proposes a variety of applicability dates. Proposed changes to Treas. Reg. Sections 1.162-15(a)(1) and (2) and 1.170A-1(c)(5) — applying IRC Section 162 to taxpayers that make payments or transfers to IRC Section 170(c) entities — would apply to payments or transfers made on or after December 17, 2019, although they may be applied to payments and transfers made between January 1, 2018 and the date that final regulations are published in the Federal Register. The safe harbors for C corporations and specified passthrough entities (in Prop. Treas. Reg. Section 1.162-15(a)(3)) would apply to payments made on or after December 17, 2019, although taxpayers may continue to apply Revenue Procedure 2019-12. The safe harbor for payments by certain individuals to or for the use of IRC Section 170(c) entities (under Prop. Treas. Reg. Sections 1.164-3(j) and 1.170A-1(h)(3)(ix)) would apply to payments made on or after June 11, 2019, when Notice 2019-12 was issued. But, the 2019 proposed regulations may be relied upon for payments made after August 27, 2018, when TD 9864 became effective, and before the instant regulations are published as final in the Federal Register. The proposed clarification of "in consideration of" (under Prop. Treas. Reg. Sections 1.170A-1(h)(1), (h)(2)(i)(B), (h)(3)(iii), (h)(4)(i) and 1.170A-13(f)(7)) would apply to payments or transfers made on or after December 17, 2019. Implications As explained in the preamble, the 2019 proposed regulations largely reduce, to regulation form, the existing views of Treasury and the IRS on the state tax credit systems relating to charitable contributions. Although this is a tax regulation, it was largely a joint undertaking between the US Department of the Treasury and the US Department of Education to provide clarity on the state tax credit systems that involve contributions made to support education. From the tax technical perspective, the most notable aspect of the 2019 proposed regulations is set forth in Example 2 to Prop. Treas. Reg. Section 1.162-15(a). The example concludes that a grocery store, operating as a partnership, that promotes a charitable pledge can deduct the amounts contributed to charity as a business expense if the partnership has a reasonable belief that it will bring additional sales due to goodwill in the community. The fact that the partnership can distribute to its partners a full credit against their respective state income tax liability does not change the result. This example is notable in several respects. First, the "reasonable belief" is a very subjective standard, but it is not a creation of the regulation. That standard articulates common law that was embodied in the regulation. Second, the IRS has informally stated that anticipating additional revenue from goodwill was not the only way that a contribution can be properly treated as a business expense as opposed to a charitable contribution. Correspondingly, it seems that other business purposes, such as increasing employee retention or increasing the quality of the workforce, could justify business deduction treatment because they reduce costs. In other words, raising revenue or making public statements about the gifts is not a prerequisite to the business deduction treatment. Finally, the example's statement that the partnership's generation of an income tax credit that its owners may apply against their individual income tax liabilities will not change the character of the deduction came as a surprise. However, the example simply stops there. It is unclear how the income tax credit allocable to its owners is treated for, say, computing the partner's tax basis in the partnership. That aspect apparently will be left for another day. ——————————————— -- For more information about EY's Exempt Organization Tax Services group, visit us at www.ey.com/ExemptOrg. ———————————————
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