Final IRS Regulations on Charitable Contributions and State and Local Tax Credits
On June 11, 2019, the U.S. Department of the Treasury and Internal Revenue Service (IRS) issued final regulations governing the relationship between federal charitable contribution deductions and state and local tax credits. These regulations finalize the proposed regulations published in August 2018 with minimal changes and require taxpayers to reduce their federal charitable contribution deduction by the amount of state or local tax credit the taxpayer receives, or expects to receive, in connection with the contribution. The final regulations are effective August 12, 2019; however, they retroactively apply to contributions made after August 27, 2018.
The Tax Cuts and Jobs Act (TCJA), enacted on December 22, 2017, limits the deduction for state and local taxes to $10,000 for taxpayers who itemize their deductions ($5,000 for married taxpayers filing separately). This is a significant change because the deduction for state and local taxes prior to TCJA was unlimited. High income and property tax states responded with workarounds to recharacterize state and local tax payments as charitable contributions, which are now limited to 60% of adjusted gross income (AGI). For example, there are state programs where taxpayers contribute to charitable organizations in exchange for a tax credit against their state and local income or property taxes. Thus, taxpayers who participate in these programs receive a greater federal tax benefit by reducing the amount of payments subject to the $10,000 limitation and converting the payments to charitable deductions.
State programs offering tax credits in exchange for contributions are not a new phenomenon. In 2010, the IRS chief counsel even advised taxpayers to deduct the full amount of their charitable contributions in exchange for a state or local tax credit. However, the significance of these programs and the recharacterization of payments became more apparent with the enactment of TCJA, and in June 2018 the IRS announced its intention to propose regulations addressing the federal income tax treatment of payments made in exchange for state and local tax credits.
On August 23, 2018, the IRS issued proposed regulations to “clarify the relationship between state and local tax credits and the federal tax rules for charitable contribution deductions.” The proposed regulations implied that taxpayers who made contributions to eligible charitable organizations after August 27, 2018 would be required to reduce their federal charitable contribution deduction by the amount of any state or local tax credit received for the contribution. For example, if a $10,000 charitable contribution created a $9,000 state income tax credit, the federal charitable contribution deduction under the proposed regulations would be $1,000. Following the release of these proposed regulations, taxpayers and practitioners scrambled to utilize the small window of opportunity to make contributions which would qualify under the old rules.
The IRS spent several months reviewing comments received on the proposed regulations and determined that approximately 70% of comments recommended finalizing the regulations without change. The final regulations issued on June 11, 2019 mostly retain the provisions in the proposed regulations, with additional clarification and technical changes. Although many comments suggested the final regulations exempt state tax credit programs established prior to the enactment of TCJA, the final regulations do not make an exception for any programs which provide state or local tax credits in exchange for contributions. The final regulations retain the general rule that when a taxpayer contributes to an eligible charitable organization and receives a state or local tax credit in return, the tax credit constitutes a return of benefit to the taxpayer. Therefore, the charitable contribution deduction must be reduced by the amount of the credit. The final regulations also retain the de minimis rule which states that federal charitable contribution deductions will not be reduced if the state or local tax credit in exchange for the contribution does not exceed 15% of the contribution. Finally, the final regulations provide that a taxpayer is not required to reduce their charitable contribution deduction for receipt of state or local tax deductions if the taxpayer expects to receive state or local tax deductions that exceed the amount contributed. If this is the case, the deduction must be reduced by the excess.
Concurrent with the final regulations, the IRS issued a notice with the intention to issue proposed regulations providing a safe harbor for individuals who contribute to an eligible organization in exchange for a state or local tax credit. Under the safe harbor, any disallowed amount of charitable contribution due to state or local tax credit received will be treated as a state and local tax payment for federal tax purposes, subject to the $10,000 limitation.
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Article prepared by Stephanie Chandler.