IRS Issues Final Regulations on State and Local Tax “Workarounds”

On June 11, 2019, the U.S. Treasury and Internal Revenue Service (IRS) issued final regulations denying charitable contribution deductions for payments to charities for which taxpayers receive state or local tax credits in exchange.  For the regulation, see https://www.federalregister.gov/documents/2019/06/13/2019-12418/contributions-in-exchange-for-state-or-local-tax-credits, and for an IRS release announcing them, go to https://www.irs.gov/newsroom/final-regulations-on-charitable-contributions-and-state-and-local-tax-credits.  The final regulations are effective August 12, 2019 but apply to all contributions made on or after August 27, 2018 when the proposed regulations denying deductions were published.

The regulations adopt, without substantial changes, the proposed regulations from August of 2018.  Although the IRS received some 7,700 written comments on the proposed regulations, and 25 people and organizations testified at a hearing held in November of 2018, the IRS made very few changes.  It said about 70% of the comments recommended adopting the proposed regulations without change.

The rules were developed in response to actions by several states, including New York, Connecticut, and New Jersey, to create “workarounds” that would minimize the $10,000 limit on state and local tax deductions imposed by the Tax Cuts and Jobs Act (TCJA).  Those efforts, which are also underway in other states, offered credits against state or local taxes for contributions to identified charities, mostly devoted to state and local welfare issues. 

The IRS rule relies on the long-established tax principle that a charitable contribution deduction may not be taken to the extent that the contributor received or expects to receive a valuable benefit in return.  If a state offers an 80% state tax credit for a contribution to a charity, then 80% of the charitable contribution is not deductible on the federal return. 

However, the rules apply to a broader spectrum of contributions than just the workarounds, affecting numerous other state and local tax credit programs, such as those subsidizing private or charter schools.  Although those other credit programs had previously been allowed, the IRS explained that the programs had never received formal scrutiny or interpretation, and that limitation of the state and local tax deduction to $10,000 had⁠—for the first time⁠—made relevant the distinction between charitable contributions and tax deductions.  Before the TCJA, it was irrelevant whether a particular amount was treated as a contribution or as taxes, since both were fully deductible.

The regulations also include two favorable taxpayer rules.  One retains a safe harbor from the 2018 proposed regulations, under which tax credits of 15% or less or the contribution will not affect deductibility of the entire contribution. 

The second announces that proposed regulations will be issued providing a safe harbor under which taxpayers who made or will make contributions subject to the final regulations will be able to treat the disallowed contributions as payments of state taxes to the extent they do not exceed the $10,000 limit.  For example, if a taxpayer makes a $5,000 contribution and receives a $5,000 state tax credit, the taxpayer may not claim the $5,000 as a charitable contribution, but may deduct the $5,000 as state and local taxes to the extent the total itemized deduction for state and local taxes does not exceed $10,000.  The IRS issued Notice 2019-12, https://www.irs.gov/newsroom/final-regulations-on-charitable-contributions-and-state-and-local-tax-credits, which explains this provision and allows taxpayers to apply the rule to returns for 2018 and later.

Further, the regulations retain the rule that contributions that are rewarded with a state and local tax deduction, as opposed to a credit, remain fully deductible as charitable contributions.

The IRS also said it would continue applying Rev. Proc. 2019-12, issued in December of 2018, which allows corporate and some pass-through businesses to continue to deduct contributions for which a tax credit is received, but plans to issue additional regulations addressing issues arising from business contributions in the near future.

Not surprisingly, state officials in high-tax states that have opposed the federal limitation and enacted the workarounds were critical of the regulations and vowed to fight them.  However, most tax professionals believe the IRS is on strong ground with the rules, and that they likely will be upheld in any litigation that ensues.  In the meantime, the four states that have sued the U.S. contending the $10,000 limitation is unconstitutional (New York, Connecticut, Maryland, and New Jersey) continue to press that suit, with oral arguments scheduled for June 18, 2019.

How This Impacts Mobility

Worldwide ERC® members may continue to face gross-up issues from transferees with high state or local taxes who are affected by the $10,000 limit and are now clearly barred from avoiding the limit through state charitable contribution workarounds. 

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