U.S. Treasury Proposes Regulations to Stop Workarounds of State & Local Tax Deduction Limit

In proposed regulations issued 23 August 2018, the U.S. Treasury says that deductions for charitable contributions will be reduced by any state or local tax credit granted in return for the contributions.

The position is explained in News Release IR-2018-172. Treasury and IRS had previously announced their intent to address the issue in a Notice issued 23 May 2018.

The 2017 Tax Cuts and Jobs Act (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.

New York, New Jersey, and Connecticut have done so, and legislation has been introduced in California, Rhode Island and Illinois.  

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 new law includes the charitable contribution workaround strategy, as do both New York and Connecticut. The effect is to create a full deduction for the taxes by converting them to charitable contributions.

Related: 4 States Sue U.S. Federal Government Over State & Local Tax Deduction Limit

As these plans have gone forward, the Treasury Department and IRS have repeatedly voiced skepticism that converting state taxes to charitable contributions will work to achieve federal tax deductions, despite some prior law suggesting that the strategy is permissible.

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.  

The regulation relies upon longstanding authority that a contribution is only deductible to the extent it is not offset by a “quid pro quo.” The tax credit is clearly a benefit that is received as a result of the contribution. Treasury explained that previous authority that seemed to ignore the rule in the case of various types of tax credit programs (for example, contributions to school choice programs) had developed during a period in which the granting of the tax credit was essentially irrelevant because either the contribution or the state taxes it replaced would be fully deductible, resulting in most cases in no federal tax effect. Under the TCJA, that is no longer the case.

Comments on the proposed regulations are due by 11 October 2018, with a hearing scheduled for 5 November 2018. Consequently, it is likely that final regulations will be in place prior to the filing season for 2018 returns.  It is also clear that, regardless of when regulations are finalized, IRS will be denying deductions and that litigation will follow.

Related: Two U.S. Senators Urge Relief for Relocated Government Employees

How This Impacts Mobility

Many transferees to or from high tax states are affected by the new TCJA limitation on deductions for state and local taxes. If they reside in or move to a state that has adopted a workaround, they will need to determine whether the risk of disallowance of a charitable deduction is worth the price of a fight with the IRS. This issue is unlikely to be finally resolved for several years. Their deduction decisions may also affect gross-up amounts. Therefore, Worldwide ERC® members should follow this issue closely.

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