This week, the IRS tried to clarify how proposed regulations on state tax credit programs apply to Section 162(a) business deductions. But its attempted clarification has created only more problems.

Under the proposed regulations, a taxpayer who makes a transfer to a Section 170(c) organization must reduce her charitable contribution deduction by the amount of any state tax credits received. See Prop. Reg. § 1.170A-1(h)(3)(i). According to the IRS, some businesses contacted the agency with concerns about those regulations. Presumably, they were worried that their transfers might not be deductible at all. That is, if Section 170 deductions were denied for creditable transfers, then Section 162 deductions might be denied too.

In IR-2018-178 (Sept. 5, 2018), the IRS cryptically announced that “taxpayers who make business-related payments to charities or government entities for which the taxpayers receive state or local tax credits can generally deduct the payments as business expenses.” See also IRS State and Local Income Tax FAQ. The IRS did not provide any further guidance on when a transfer to a state tax credit program will qualify as “business related.”

Existing authorities suggest a high standard. Under Treas. Reg. § 1.170A-1(c)(5), transfers to Section 170(c) organizations may be deductible under Section 162 only when they “bear a direct relationship to the taxpayer’s trade or business” and “are made with a reasonable expectation of financial return commensurate with the amount of the transfer.” Thus, for example, when a company makes a transfer to a Section 170(c) hospital in exchange for “a binding obligation on the part of the hospital to provide hospital services and facilities for the company’s employees,” the company will enjoy a Section 162 deduction. See Treas. Reg. § 1.162-15(a)(2).

It is far from clear how this regulatory framework applies to state tax credit programs. And it may be challenging for a taxpayer to show why a creditable transfer to, for example, a school choice program bears a “direct relationship” to the taxpayer’s business. But Secretary Mnuchin assured taxpayers that recent statutory amendments had “no impact on federal tax benefits for business-related donations to school choice programs.”

Taken literally, Mnuchin’s statement does not establish that a business’s creditable transfer to a school choice program automatically establishes a Section 162 deduction. That transfer would have to meet the usual standards under the regulations and case law. If so, it is difficult to understand why Mnuchin offered specific assurances about creditable transfers and school choice programs.

Arguably, the state tax credit that arises from a transfer to a school choice program itself provides the financial return that establishes a Section 162 deduction. Thus, transfers to school choice programs become automatically deductible. And, if the IRS plays fair, state tax credits arising under other programs would also establish the financial return needed to justify Section 162 deductions.

But this approach would allow individual business owners to easily escape the Section 164 limit on deductible state income taxes. They could simply make transfers to state tax credit programs and enjoy full Section 162 deductions, while wiping out their state tax liabilities. (A direct payment of state income taxes would face deduction limits under Section 164(b)(6).) That seems like a major loophole, and the IRS should clarify its recent guidance. Either a small gesture has been made towards state tax credit programs or the white flag has been raised. The IRS should specify which.

The IRS should also address the contradictions between its new guidance and the proposed regulations. Those regulations state that when a taxpayer makes a transfer to a state tax credit program, the credits received are “consideration” for the taxpayer’s transfer. See Prop. Reg. § 1.170A-1(h)(3)(i). In other words, the taxpayer has purchased those credits. Thus, the taxpayer’s transfer should not give rise to any immediate deduction under Section 162. Rather, the taxpayer should acquire a cost basis in the state tax credits. See Section 1012. See also Reg. § 1.263(a)-4(c)(1) (“A taxpayer must capitalize amounts paid to another party to acquire any intangible from that party in a purchase or similar transaction.”). Business taxpayers who acquire tax credits through state charitable programs should thus enjoy deductions only when those credits are used to satisfy their tax liabilities. See Section 164.

But the new IRS guidance does not even mention Section 164. My prior post noted that the proposed regulations suffer from gaps and conceptual flaws that will confuse taxpayers, and the IRS’s latest guidance makes things even worse. One hopes that the agency actively incorporates public feedback as it proceeds through the rulemaking process.

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(This post may be updated. Comments appreciated.)