As expected, the IRS on Tuesday put the kibosh on state programs designed to help taxpayers circumvent the newly imposed $10,000 federal limitation on the state and local tax (“SALT”) deduction. The final regulations come after the Treasury Department issued proposed regulations on the topic last August.
Under the new federal tax law passed in December 2017, the amount of state and local taxes one can deduct is capped at $10,000. In response, some higher taxing states, including New York and New Jersey, took steps to get around the limitation by enacting legislation meant to convert state and local taxes to charitable contributions. Under the workarounds, taxpayers could donate to state and local funds and receive tax credits to apply against their state and local taxes. The intention was for the taxpayers to then deduct the donations to these funds as charitable contributions on their federal returns, which are not subject to the limitation.
But the IRS has now barred such workarounds, saying that the receipt of a state or local tax credit in return for making such a contribution would constitute a “quid pro quo.” The net effect is a reduction in the amount of federal deductions a taxpayer can claim for these charitable contributions. According to the final regulations, taxpayers can only receive a federal deduction for a charitable contribution that is greater than the amount of the tax credits they received. This means that a taxpayer who makes a $40,000 charitable donation to a municipal fund to pay for property taxes and receives a $35,000 state tax credit would only be able to claim a deduction of $5,000 on his federal tax return.
In addition to the state and local tax workarounds, the new regulations also impact pre-existing funds in states where residents have been entitled to tax credits for donations to school voucher programs, ranging from conservation easements to private school tuition scholarships. For years, states like Alabama, South Carolina and Georgia have offered dollar-for-dollar credit programs supporting various state causes. The new tax guidance, however, will likely deter taxpayer contributions going forward.
The IRS regulations did include two provisions giving taxpayers some latitude. First, taxpayers who have contributed to a workaround fund can elect to have some of the charitable contributions treated as state and local taxes. This will allow taxpayers to claim as much of the $10,000 cap as possible. And second, in situations where the state credit received is 15% or less of the total donation, taxpayers do not have to subtract the amount of the tax credit for federal charitable donation purposes.
While these regulations have widespread application, they do not address other state legislation that circumvents the state and local tax limitation. For example, Connecticut implemented a pass-through business tax in which income taxes are paid at the entity level, thereby escaping state tax at the partner level and thus not subject to the SALT deduction limitation on their federal return. How the IRS will treat these schemes is unknown.
If you have questions regarding the impact of the new IRS regulations on your taxes, please contact us.