On August 23, 2018, IRS issued REG-112176-18, proposed regulations intended to stop states from establishing charitable contribution/tax credit schemes to get around the new $10,000 limit on deductions for state and local taxes. The proposed regulations also reach some longstanding state credit programs designed to encourage charitable contributions for purposes such as school tuition.
What is a charitable contribution?
In 1986, the Supreme Court interpreted the phrase “charitable contribution” in U.S. v. American Bar Endowment, 477 U.S. 105, 116-118 (1986) as “a transfer of money or property without adequate consideration”—that is, without the expectation of quid pro quo. A “payment of money generally cannot constitute a charitable contribution if the contributor expects a substantial benefit in return”. The Court recognized that some payments may have a “dual character”—part charitable contribution and part quid pro quo—whereby the taxpayer receives some “nominal benefit” of lesser value than the payment. In such cases, the Court reasoned, “it would not serve the purposes of § 170 to deny a deduction altogether.” Instead, the charitable contribution deduction is allowed, but only to the extent the amount donated, or the fair market value of the property transferred by the taxpayer exceeds the fair market value of the benefit received in return, and only if the excess amount was transferred with the intent of making a gift.
In other words, if you donate to a charitable organization and get something in return, the contribution is allowed but it must be reduced by any benefit received.
The enactment of the TCJA and the limit placed on the deductibility of state and local taxes under §164(b)(6), caused states to create programs where taxpayers could make a charitable contribution in exchange for a state credit. This theoretically would allow taxpayers to circumvent the $10,000 limitation in § 164(b)(6) by substituting an increased charitable contribution deduction for a disallowed state and local tax deduction. IRS issued Notice 2018-54 on May 23, 2018, announcing its intent to propose regulations to address the issue. What Notice 2018-54 did not say was that the proposed regulations would address other state credits that have been in place for years. The preamble to the proposed regulations states, “the rules in these proposed regulations are based on longstanding federal tax law principles, which apply equally to taxpayers regardless of whether they are participating in a new state and local tax credit program or a preexisting one.”
The gist of the proposed regulation is that when a taxpayer receives or expects to receive a state or local tax credit in return for a payment or transfer to an entity listed in IRC § 170(c), the receipt of this tax benefit constitutes a quid pro quo that may preclude a full deduction under § 170(a). Thus, the amount otherwise deductible as a charitable contribution must generally be reduced by the amount of the state or local tax credit received or expected to be received, just as it is reduced for many other benefits.
This position will impact donations to existing state programs, such as Iowa’s School Tuition Organization program or Endow Iowa.
Example 1 (corresponding to example 1 in the proposed regulations)
Adam, an individual, makes a payment of $1,000 to Iowa’s School Tuition Organization (STO), a charitable organization that raise tuition grant funding for eligible students who enroll in accredited nonpublic schools in Iowa, an entity listed in § 170(c).
In exchange for the payment, Adam receives or expects to receive a state tax credit of up to 65% of the amount of the payment to the STO. Adam’s charitable contribution deduction is reduced by $650 (65% x $1,000). This reduction occurs regardless of whether Adam can claim the state tax credit in that year. Thus, Adam’s charitable contribution deduction on the federal return for the $1,000 payment to Iowa’s STO may not exceed $350.
De Minimis Provision
The proposed regulation allows for a de minimis provision where a reduction of the contribution in exchange for the credit will not apply. If the amount of the state or local tax credit received or expected to be received by the taxpayer does not exceed 15 percent of the taxpayer’s payment, or 15 percent of the fair market value of the property transferred by the taxpayer, no reduction of the charitable contribution is required.
Example 2 (corresponding to Example 2 in the proposed regulations)
Beth, an individual, transfers a painting to a qualified charitable organization, an entity listed in § 170(c). At the time of the transfer, the painting has a fair market value of $100,000. In exchange for the painting, Beth receives or expects to receive a state tax credit equal to 10% of the fair market value of the painting. Beth is not required to apply the general rule because the amount of the tax credit received or expected to be received by her does not exceed 15% of the fair market value of the property transferred. Accordingly, the amount of Beth’s charitable contribution deduction for the transfer of the painting is not reduced.
Deduction vs. Credit
The proposed regulations state that if a taxpayer makes a payment or transfers property to a charitable organization with the expectation of receiving a state or local tax deduction that does not exceed the amount of the payment or the fair market value of the property, the federal charitable contribution deduction need not be reduced.
Example 3 (corresponding to Example 3 in the proposed regulations)
Clark, an individual, makes a payment of $1,000 to an entity listed in § 170(c). In exchange for the payment, under state law, Clark is entitled to receive a state tax deduction equal to the amount paid. Clark is not required to reduce its charitable contribution deduction under § 170(a) because of the state tax deduction. Dollar for dollar deductions are allowed as no tax benefit is received.
Request for Comment
The agencies are requesting comments on the following:
- Whether there should be a rule that would allow taxpayers to decline state or local tax credits and receive full deductions for charitable contributions.
- Whether there should be recognition of gain or loss when property is transferred in consideration for state or local tax credits that are not de minimis.
- Determination of the basis of a transferable tax credit that a taxpayer sells or exchanges.
- Procedures by which a taxpayer may establish that the taxpayer declined receipt of the state or local tax credit.
- Substantiation and reporting requirements for donors and donees making or receiving payments or transfers of property in return for state and local tax credits.
- For a taxpayer that receives or expects to receive a state or local tax deduction in an amount that exceeds the amount of the taxpayer’s payment or the fair market value of the property transferred to an entity listed in § 170(c), suggestions for calculating the reduction to the charitable contribution deduction; and
- Whether and in what manner the regulations should address other state or local tax benefits, such as tax exclusions, that may be provided as consideration for certain payments or transfers to an entity listed in§ 170(c).
Finally, the Treasury Department and the IRS request comments on alternative regulatory approaches that would effectively prevent circumvention of the new statutory limitation on state and local tax deductions, consistent with applicable law.
These new regulations are proposed to apply to contributions after August 27, 2018.