In Proposed Regs 112176-18 issued August 23, 2018, IRS put a major damper on efforts to skirt the TCJA’s state and local tax deduction cap. I have found in talking to various professionals that these so-called SALT deduction workarounds are not very well understood in practice or effect. So, let’s start with a basic understanding of precisely what we’re discussing.
A number of states have contemplated enacting legislation to allow taxpayers to make payments to state run charities to fulfill their state tax obligations. The taxpayer could then take a federal deduction on Schedule A for a charitable contribution, thus circumventing the $10,000 limitation only applicable to state and local taxes. Of course, the state would also wink and accept this ostensible charitable contribution in full satisfaction of its taxes. This does seem a little 3 Card Monte-ish, no? A state accepting a so-called charitable contribution to fulfill a state tax bill in order to create an otherwise unavailable federal deduction – this just doesn’t hit me square. It’s akin to an American League pitcher beaning a batter, then hiding behind the DH rule knowing he doesn’t have to come up to the plate and face his own chin music. This just seems fundamentally way off. What if my state did not set up one of these programs? We are to reward residents of some states over others? And I am no Constitutional scholar, but it would seem the Supremacy Clause would have something to say about all this. Doesn’t federal law prevail over conflicting state exercises of power? Well, the IRS certainly took action illustrative of this sentiment.
Under the proposed regulations, a taxpayer who makes payments or transfers property to an entity eligible to receive tax deductible contributions must reduce their charitable deduction by the amount of any state or local tax credit the taxpayer receives or expects to receive. There is a de minimis exception under which a taxpayer may disregard a state or local tax credit if such credit does not exceed 15% of the taxpayer’s payment or 15% of the fair market value of the property transferred. Another exception is provided for dollar-for-dollar state tax deductions. These rules are best understood through the examples that follow.
Example 1 A, an individual, makes a payment of $1,000 to X, an entity listed in Section 170(c). In exchange for the payment, A receives or expects to receive a state tax credit of 70% of the amount of A’s payment to X. A’s charitable contribution deduction is reduced by $700 (70% x $1,000). This reduction occurs regardless of whether A is able to claim the state tax credit in that year. Thus, A’s charitable contribution deduction for the $1,000 payment to X may not exceed $300. This example illustrates the general rule.
Example 2 B, an individual, transfers a painting to Y, an entity listed in Section 170(c). At the time of the transfer, the painting has a fair market value of $100,000. In exchange for the painting, B receives or expects to receive a state tax credit equal to 10% of the fair market value of the painting. B is not required to apply the general rule because the amount of the tax credit received or expected to be received by B does not exceed 15% of the fair market value of the property transferred to Y. Accordingly, the amount of B’s charitable contribution deduction for the transfer of the painting is not reduced. This example illustrates the 15% de minimis exception.
Example 3 C, an individual, makes a payment of $1,000 to Z, an entity listed in Section 170(c). In exchange for the payment, under state M law, C is entitled to receive a state tax deduction equal to the amount paid by C to Z. C is not required to reduce the charitable contribution deduction on account of the state tax deduction. This example illustrates the dollar-for-dollar situation in which the state or local tax deduction does not exceed the taxpayer’s payment or fair market value of the property transferred, and as such, taxpayer is not required to reduce the charitable contribution deduction.
These new rules that eliminate SALT deduction workarounds will affect many of your clients. Despite not being relevant for filers taking the standard deduction, your itemized Schedule A filers probably represent a good portion of your paying returns. Sitting here in suburban Philadelphia, the Commonwealth of Pennsylvania will collect $6,140 in taxes from a couple with joint income of $200,000. Add in rapidly increasing property taxes, and it’s easy to see how the total can creep above the $10,000 limitation.
As new guidance is coming out from the IRS on almost a daily basis, make sure to take our Tax Reform Overview: Post-Tax Season Update (TARU) for detailed information on these new SALT rules and all other relevant and timely tax reform topics.
Nick Spoltore is VP of Tax & Advisory Content for Surgent CPE. Mr. Spoltore is a graduate of the University of Notre Dame and of Delaware Law School. Before joining Surgent, he practiced tax and business law at the firm of Heaney, Kilcoyne in Pennsylvania and also in Delaware.