State Tax Credit Programs for Charitable Contributions
Before the TCJA, more than 30 states had school choice and other tax credit programs in place to provide breaks to taxpayers for making charitable donations. The federal income tax treatment of payments and property transfers under state and local tax credit programs wasn't an issue. Why? The payment or transfer could be taken as an itemized deduction on the taxpayer's federal income tax return, regardless of whether the amount was characterized as a payment of state tax or a charitable contribution. (See "Deducting Charitable Contributions" above.)
The IRS allowed taxpayers to claim a deduction for the full amount of the contribution made in return for a state tax credit, without subtracting the value of the credit. The government generally didn't try to regulate state tax credit programs because they didn't affect how much tax revenue the IRS collected.
Under the TCJA, however, the characterization of a payment or transfer to a state or local tax credit program is relevant, because of the new SALT deduction limit. To bypass the SALT limitation, lawmakers in some high-tax states have turned to state and local tax credit programs. The workaround programs provide tax credits in return for contributions by taxpayers to or for the use of an eligible state agency or charitable organization.
For example, New York has established new "charitable gifts trust funds" to which taxpayers can make charitable contributions and claim a tax credit equal to 85% of the donation. Similarly, New Jersey enacted legislation that permits localities to establish charitable funds to which taxpayers can contribute and receive a 90% New Jersey property tax credit. The intention is that these contributions can be claimed as a charitable deduction on federal tax returns, to help make up for deductions lost due to the SALT limit.
So, the IRS issued proposed regs to prevent charitable contributions from being used to circumvent the new limit on SALT deductions.
Proposed Regulations on SALT Limitation
The proposed SALT limitation regs eliminate the benefit of charitable contribution workarounds enacted by the states. The IRS has concluded that, "when a taxpayer receives or expects to receive a state or local tax credit in return for a payment or transfer to [an eligible entity], the receipt of this tax benefit constitutes a quid pro quo that may preclude a full deduction."
Under the proposed regs, if you make payments or transfer property to an entity eligible to receive tax deductible contributions, you'll have to reduce your federal charitable deduction by the amount of any state or local tax credit received.
For example, suppose you make a $10,000 contribution to an eligible entity that entitles you to an $8,500 state tax credit and you itemize deductions on your federal return, so that you can deduct your qualified charitable contributions. Under the proposed regs, your charitable contribution deduction must be reduced by the tax credit. So, only the net value of the contribution ($1,500) would be deductible on your federal income tax return.
The proposed regs apply to new and existing state and local tax credit programs. But they don't apply to dollar-for-dollar state and local tax deductions. Although state and local tax deductions could be considered quid pro quo benefits in the same manner as credits, the benefit of a dollar-for-dollar deduction is limited to the taxpayer's state and local marginal rate. So, the risk of deductions being used as a workaround is comparatively low.
However, if a taxpayer receives or expects to receive a state and local tax deduction that exceeds the amount of the payment or the fair market value of the property transferred, his or her charitable contribution deduction would have to be reduced.
Important note: The proposed regs also don't apply to state and local tax credits of 15% or less of the cash paid, or of the fair market value of the property transferred, to the state. So, if you make a $10,000 contribution to an eligible entity and the state tax credit received or expected to be received is $1,500 or less, you won't be required to reduce your federal deduction.
In a recent IRS press release Treasury Secretary Steven T. Mnuchin said, "Congress limited the deduction for state and local taxes that predominantly benefited high-income earners to help pay for major tax cuts for American families. The proposed rule will uphold that limitation by preventing attempts to convert tax payments into charitable contributions. We appreciate the value of state tax credit programs, particularly school choice initiatives, and we believe the proposed rule will have no impact on federal tax benefits for donations to school choice programs for about 99% of taxpayers compared to prior law."
For More Information
The new regs are in proposed form, but taxpayers can rely on them until final regulations are issued. The proposed regs apply to contributions made after August 27, 2018.
Contact your tax advisor for more information about this new limitation and other provisions of the TCJA. He or she can help you determine whether it will make sense for you to itemize deductions for 2018 and how that impacts your year-end tax planning, as well as brainstorm other saving strategies under the new law, based on your circumstances.