There is a lot of concern, and possibly even misconceptions, regarding the (practical) impact of the proposed charitable contribution regulations that were issued last week. In particular, there is much angst over the impact those regulations may have on gifts made to organizations, particularly for programs supporting education, that generate state tax credits. The proposed regulations were issued in response to the efforts by a number of states to reduce the impact of the $10,000 ceiling on the deductibility of state and local taxes. These states are attempting to accomplish this by creating charitable organizations, administered by the state that would accept “donations” in exchange for granting credits that could be used against state income tax liabilities.
As an example, rather than pay $50,000 to the state as state taxes and be limited to a deduction of $10,000, some states are advocating that individuals donate the same $50,000 to a state-established charitable organization. This donation would entitle the donor to a $50,000 tax credit against his or her state tax liabilities (thereby not requiring a direct tax payment to the state). This would convert $40,000 of otherwise non-deductible state tax payments to a deductible charitable contribution.
Prior to the recent tax changes, there were already rules in place disallowing a charitable deduction when there is an expectation of a benefit in return. The question is whether the receipt of state tax credits in exchange for donations is a significant benefit that should limit the charitable deductibility of the payment.
Whether the IRS decided in the past to pursue or not pursue the issue is another matter. Prior to 2018 though, the IRS was aware of the issue and appeared to have chosen not to address it by not issuing previous guidance. However, the Tax Cuts and Jobs Act and the subsequent state workarounds changed the IRS’s approach.
With the issuance of the proposed regulations, the IRS position is now clear that taxpayers should not expect to obtain both a state tax credit and a federal charitable deduction (except in very limited circumstances where the credit or benefit received is no more than 15% of the donation) for payments made after August 27. This new approach could impact existing education programs. The IRS’s broad position appears to be rooted in the belief it is unable to allow one type of payment generating a state tax credit to be treated as a charitable deduction (such as a contribution to a qualifying educational institution) while denying a deduction for other “charitable” programs established by states to work around the SALT itemized deduction limitation. However, the underlying law has not changed; what has changed is that now there is written guidance in the form of the proposed regulations.
So what is the practical implication for people who want to donate to organizations that provide tax credits in exchange for the contribution? Interestingly, it is not always as significant as one might think, as there is still a state tax credit available, and there is still a charitable deduction available for the piece of the donation not generating a credit.
Although taxpayers may not use these programs to circumvent the state tax limitation, a contribution through such a program may still remain a very viable option to paying the taxes directly. Taxpayers should evaluate their current tax situation to determine the benefits.
At Schneider Downs, we help you with the practical implications of the tax law and work to optimize your tax situation while helping you achieve your personal financial goals and objectives. Please do not hesitate to call one of our tax professionals to discuss these and other options with you.
