After Congress passed the Tax Cuts and Jobs Act, several states adopted a charitable contribution strategy to help their residents avoid the new Section 164 deduction limits for state and local tax payments. Under the strategy, taxpayers would make donations to state-controlled funds and receive state tax credits for those donations. Taxpayers would then use the credits received to offset their state tax liabilities.
If there were no further consequences, the transaction would be a wash. Taxpayers would have simply replaced their state tax payments with state donations. However, the charitable contribution strategy contemplates that the taxpayer’s donation will be federally deductible under Section 170. Thus, the charitable contribution strategy, if effective, allows the taxpayer to replace nondeductible state tax payments with deductible donations.
My article, The Charitable Contribution Strategy: An Ineffective SALT Substitute, 38 Virginia Tax. Rev. — (2018), argues that the charitable contribution strategy fails under existing law. The article acknowledges several different argumentative paths, but the best analysis characterizes the strategy in two parts. First, the taxpayer’s transfer to the state-controlled fund should be treated as an arm’s length exchange for state tax credits. And second, the state tax credits acquired on that exchange, when applied against the taxpayer’s tax liability, should give rise to tax payments that face the Section 164 deduction limits. See id. at Part II.C.b. The Article argues that the IRS should issue regulations adopting that two-part approach.
The IRS just issued proposed regulations on the charitable contribution strategy, and I was pleased to see that they are consistent with the first part of my analysis. That is, they treat a donation to a state-controlled fund as a quid pro quo transaction for state tax credits. See Prop. Reg. § 1.170A-1(h)(3), REG-112176-18. However, the regulations do not discuss the consequences associated with the later use of state tax credits.
Under Prop. Reg. § 1.170A-1(h)(3)(i), a taxpayer who makes a payment to an entity described in Section 170(c) (which reaches state-controlled funds) must reduce her otherwise allowable charitable contribution deduction by the amount of any state tax credit that she “receives or expects to receive in consideration” for her transfer. See also Preamble, p.9 (state tax credit that arises through the transfer “constitutes a quid pro quo that may preclude a full deduction under section 170(a)”). The regulations thus plainly and properly treat the taxpayer as having received state tax credits as “consideration for” her payment. This rule suffices to deny the benefits sought under the charitable contribution strategy, and it is understandable why the regulatory guidance stops there.
However, taxpayers will want to know how the state tax credits they acquired will be treated in later transactions. Sometimes, the tax consequences might be straightforward, such as when the taxpayer fully applies the credit she acquired against her tax liability (Section 164 would apply there). But tougher issues arise when state tax credits are sold or when they expire. If, as part of this regulation project, the IRS will not describe the later tax consequences associated with state tax credits considered purchased under Prop. Reg. § 1.170A-1(h)(3)(i), the agency should, at the very least, solicit public comments on the relevant issues.
The regulations also raise other potential issues that will benefit from comments. For example, the regulations apply exchange treatment even when state tax credits do not come from the organization to which the taxpayer transferred money. See Prop. Reg. § 1.170A-1(h)(3)(iii). This approach was probably adopted so that Section 170 deductions would not be allowed for creditable donations to private charities. But no quid pro quo can exist when a taxpayer transfers money to a private charity and the state independently grants a credit to the taxpayer. The IRS can and should address creditable donations to private charities, but not through this conceptually incoherent approach.
Though the proposed regulations contain warts, the IRS should be commended for acting relatively quickly and responsibly to address troublesome state strategies. Additionally, though the IRS oftens skips notice and comment procedures and immediately imposes burdensome regulations on the public, the IRS acted here through proposed regulations. It should be commended for (gradually) observing the Administrative Procedure Act’s safeguards. One hopes that the IRS meaningfully responds to public comments and that the final regulations provide clear, consistent, and sound rules for taxpayers.
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