U.S. IRS Clarifies Deduction Rules for Certain Charitable Contributions

On 28 December, 2018, the Internal Revenue Service clarified earlier informal guidance concerning the extent to which businesses may deduct charitable contributions that result in the business receiving state or local tax credits.  See Rev. Proc. 2019-12.  

The issue stems from the government’s attempts to stymie high-tax states that have attempted to “work around” the limit imposed on individual deductions for state and local taxes by the 2017 Tax Cuts and Jobs Act (TCJA).

The TCJA limits individual itemized deductions for all state taxes (income, property, sales) to $10,000, beginning in 2018.  Under prior law, such deductions were unlimited.  The new limitations adversely affect taxpayers in high tax states.  A number of such states have reacted by considering or enacting provisions that would effectively convert the taxes to forms of levies that remain fully deductible.

The primary focus of “workaround” legislation has been to create state or local charitable entities to which individual taxpayers may contribute.  Taxpayers get an income or property tax credit for the contributions.  The states maintain that the contributions are fully deductible for federal income tax purposes as charitable contributions.  New Jersey’s law includes the charitable contribution workaround strategy, as do New York, Oregon, and Connecticut.  The effect is to create a full federal deduction for the taxes by converting them to charitable contributions.

The IRS responded with proposed regulations denying most such deductions.  The proposed regulations address not only state and local charitable organizations, but all charities, and hold that any time a tax credit is given in return for a contribution, the deduction for the contribution must be reduced by the credit.  An exception is included for credits that do not exceed 15% of the contribution.  Contributions that result in a dollar-for-dollar state tax deduction (as opposed to a tax credit) are also permissible.  

However, questions rapidly arose as to the treatment of such contributions made by businesses, as opposed to individuals.  

The IRS clarified in IR-2018-178 (September 5, 2018) that the proposed regulations do not apply to contributions by businesses that would otherwise be fully deductible as business expenses.  Still, numerous questions remained unanswered, and IRS has now provided some answers in Rev. Proc 2019-12.

The Rev. Proc. provides a “safe harbor” under which businesses making charitable contributions for which a state or local tax credit is received may deduct such contributions as business expenses.  The safe harbor deduction, however, is limited to the amount of the tax credit received.  Consequently, if a corporation makes a contribution of $1,000, for which it receives a state tax credit of $800, it is automatically allowed to deduct $800 as a business expense.  The treatment of the remaining $200 is dependent upon whether the facts and circumstances demonstrate that it was an ordinary and necessary expense of conducting the business, made with a business purpose.  

The same safe harbor is also made available to “pass-through” entities such as partnerships and S-corporations, but only to the extent the tax credit offsets taxes owed by the business itself (such as local property taxes, or state excise taxes).  If the contribution would result in tax credits for state or local taxes owed by the individual owners, the availability of a deduction for the individuals is governed by the TCJA limit, as interpreted by the IRS in its proposed regulations.  That is, if a partnership makes a contribution of $1,000 which would result in state income tax credits of $500 against the state income tax liability of each of its two partners, the contribution will not be deductible by the partnership as a business expense.

How This Impacts Mobility

Worldwide ERC® member companies can be assured that charitable contributions made that are offset by state or local tax credits are generally deductible without regard to the limit on individual deductions for state or local taxes, unless the contributions result in tax credits for taxes owed by individual owners.

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