Prior to the Tax Cuts and Jobs Act of 2017 (TCJA), taxpayers could deduct the full amount of the state and local tax (SALT) payments as an itemized deduction on their federal income tax return. For tax years 2018-2025, the TCJA limits the deductibility of SALT payments per IRC §164(b)(6), which includes real and personal property taxes and income taxes, to $10,000 ($5,000 if married and filing separately). Therefore, regardless of whether a taxpayer files as a single, married filing jointly, or head of household taxpayer, the maximum SALT deduction is $10,000 per year.
STATES MOVE TO REDUCE IMPACT
This change raised the ire of some state legislatures and governors. New Jersey Governor Phil Murphy, for example, recently signed into New Jersey law legislation permitting localities to establish local charitable funds whereby individuals can make contributions and take a credit on their New Jersey property tax bill (per New Jersey Statutes Annotated §54:4-66.9) of up to 90% of their contribution for fiscal years beginning on or after January 1, 2018.
Other high-tax states are similarly looking at possible ways to minimize the effect of the SALT limitation. According to McKinney’s Consolidated Laws of New York Annotated §980-a, for example, New York has established a state-administered charitable trust fund to support a variety of services to New Yorkers. Taxpayers contributing to this trust fund can take a tax credit against their state income taxes of up to 95% of the contribution; however, the donation must be received in the 12-month period prior to the last day that the taxes may be paid without interest or penalties.
In addition, New York employers have the option to pay an additional payroll tax on the employee’s wages above $40,000 and provide the employee with a tax credit to offset the loss of wages (see New York State Department of Taxation and Finance Technical Memorandum TSB-M-18(1)ECEP, July 3, 2018).
For example, let’s assume an individual has a state income tax of $10,000 and a property tax of $12,000. Under the TCJA, the taxpayer can only claim $10,000 of the $22,000 ($10,000 + $12,000) of the total state and local taxes as an itemized deduction. But if the taxpayer elects to make a $12,000 contribution to the newly established “local charity,” the state allows the individual under the contribution/credit legislation to take a credit of up to $10,800 (90% of $12,000) toward his or her local property taxes. The net result of this transaction (assuming it satisfies federal income tax laws) is the taxpayer can claim a $12,000 charitable contribution and be limited to a $10,000 state and local taxes deduction on federal income tax. And even better, the taxpayer is relieved of $10,800 of the $12,000 property taxes that were due, thus receiving a benefit in consideration for the “donation.”
RESPONSE BY THE TREASURY AND IRS
In response to the states’ introductions of charitable funds, the U.S. Department of the Treasury and the IRS issued IRS Notice 2018-54 on May 23, 2018, which indicates that proposed regulations will be issued addressing the deductibility of SALT payments for federal income tax purposes. On August 23, 2018, the Treasury issued proposed regulations (REG-112176-18) providing rules on the availability of charitable contribution deductions when the taxpayer receives or expects to receive a corresponding state or local tax credit.
The preamble of the proposed regulations specifically state that the Treasury request public comments on alternative regulatory approaches that would effectively prevent circumvention of the new statutory limitation on the state and local tax deduction. The concern is the precedent that would be set by allowing the states’ workaround policies to not take into account the value of all state tax benefits received or expected to be received in return for charitable contributions. This would precipitate significant revenue losses that would undermine and be inconsistent with the limitation on the deduction for state and local taxes adopted by Congress in IRC §164(b)(6).
Treasury held that considering the long-standing principles of cases and tax regulations, a taxpayer can’t claim a full charitable contribution deduction if he or she receives or expects to receive a state or local tax credit in return for a payment or transfer to a qualified organization described in IRC §170(c). The rationale is that the tax credit constitutes a benefit to the taxpayer. The following example given in News Release 2018-172 (August 23, 2018) illustrates this position:
If a state grants a 70% state tax credit and the taxpayer pays $1,000 to an eligible entity, the taxpayer receives a $700 state tax credit. He or she must reduce the $1,000 contribution by the $700 state tax credit, leaving an allowable contribution deduction of $300 on the taxpayer’s federal income tax return. The proposed regulations also apply to payments made by trusts or decedents’ estates in determining the amount of the contribution deduction (see IRC §642(c)).
The proposed regulations also provide a de minimis exception for dollar-for-dollar state tax deductions and for tax credits of no more than 15% of the payment amount or of the fair market value of the property transferred. The de minimis exception reflects the combined value of a state and local tax deduction (that is, the combined top marginal state and local tax rate) that currently doesn’t exceed 15%.
Accordingly, under the proposed regulations, a state or local tax credit for a charitable contribution that doesn’t exceed 15% won’t reduce the taxpayer’s federal deduction for a charitable contribution. For example, a taxpayer who makes a $1,000 contribution to an eligible entity isn’t required to reduce the $1,000 deduction on his or her federal income tax return if the state or local tax credit received or expected to be received is no more than $150.
Expect to hear more on this issue as public comments were solicited and a public hearing on the proposed regulations was scheduled for November 5, 2018. Since the proposed regulations are effective for amounts paid or property transferred by a taxpayer after August 27, 2018, the 2018 tax filing season is now likely to be even more interesting than it was going to be already with all the changes introduced by the TCJA.
© 2018 A.P. Curatola
November 2018
