On August 23, 2018, the U.S. Department of the Treasury and the Internal Revenue Service (IRS) responded to efforts by New York, New Jersey, and Connecticut to bypass the Tax Cuts and Jobs Act’s $10,000 cap for the state and local tax (SALT) deduction. Treasury issued proposed regulations intended to explain the relationship between the ability to claim a charitable contribution deduction under IRC section 170 and state and local tax credits. The proposed regulation indicates that it applies to contributions made after August 27, 2018. The plans adopted by New York, New Jersey, and Connecticut to alleviate the impact of the $10,000 cap on the federal SALT deduction by allowing residents to make deductible charitable contributions in exchange for a state income tax credit are generally not acceptable under the proposed regulations. The governors of all three states have issued statements in response to the proposed regulation, stating they will explore all options to protect their citizens from the SALT deduction limitation.
Based on existing regulations and case law interpreting what constitutes a “charitable contribution,” the proposed regulations clarify that a deduction will not be allowed when a contributor expects a substantial benefit in return. The supplemental information published along with proposed regulation 112176-18 provides that “when a taxpayer receives or expects to receive a state or local tax credit in return for a payment or transfer . . . the receipt of this tax benefit constitutes a quid pro quo that may preclude a full deduction under section 170(a).” Thus, under the proposed regulations, if a taxpayer makes a contribution or gift to an entity listed in IRC section 170(c), such as the charitable contribution trust funds set up by New York, and the taxpayer receives or expects to receive a state or local tax credit in return, the taxpayer’s charitable contribution deduction is reduced by the amount the tax credit.
However, the proposed regulations do not categorically disallow state or local tax benefits in exchange for a contribution in all cases. A de minimis exception is provided for in the proposed regulations, which will not require a reduction to a taxpayer’s charitable contribution deduction if the tax credit received is no more than 15% of the contribution amount or fair market value of the gift. Additionally, the regulation generally permits a state to allow a state income tax deduction for contributions made to public charities so long as the deduction is not more than the amount contributed.
The significant limitation placed on the SALT deduction will be felt most in high-tax states such as New York, California, and New Jersey. Residents of these states can have SALT deductions significantly higher than the new $10,000 limit. Still, states have sought other methods to circumvent the new SALT limitation. For example, Connecticut has enacted a new pass-through entity tax (PET) imposed on partnerships and S corporations. The new PET is imposed directly at the entity level, as opposed to the flow-through treatment used by most states. The new PET circumvents the $10,000 SALT deduction limitation because a business entity tax would be fully deductible on the business’ federal income tax return, unlike the personal income taxes passed through to a pass-through entity’s members or partners.
Interestingly, although the proposed regulation states they are intended to clarify the relationship between the federal charitable contribution deduction and the new limitation on the SALT deduction, the regulation provides that the amendments apply to contributions made after August 27, 2018. Therefore, the ability to deduct contributions made prior to that date is somewhat unclear. Still, New York’s governor has alerted its citizens to contribute to the charitable funds before the applicability date of the proposed regulation.
The impacted states are also vying to hit back at the proposed regulations, with Governor Cuomo of New York asserting that his state’s recently enacted opportunities for charitable contributions to state and local governments are consistent with federal law and that New York “will use every tool at our disposal, including litigation, to fight back.” A similar sentiment was reflected by the Governors of New Jersey and Connecticut. Governor Murphy of New Jersey stated that all legal avenues will be examined, while Connecticut Governor Malloy said the state will assess its options for responding to what he labeled as an “affront to middle-class Connecticut families.”
Taxpayers would be ill-advised to interpret the August 28, 2018 applicability date as permitting charitable contributions to state and local funds in exchange for a state tax credit prior to that date as being deductible for federal income tax purposes. A body of law already exists that disallows a charitable contribution when a taxpayer receives a substantial tax benefit in return. The August 28, 2018 applicability date more likely applies to the creation of di minmis exception discussed above.
If you have questions on the new SALT deduction limitation or other tax reform items, please contact Michael L. Colavito or one of our tax advisors at 301.2316200.