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Impact of IRS regulations on state credits for charitable contributions

October 19, 2018

By Scott Brawdy, CPA, Tax Manager and SALT Practice Leader
Garrett Jerzyk, CPA, Senior Tax Associate

Proposed regulations issued by the IRS are putting a halt to states’ plans to offer state-sponsored charitable contribution programs to circumvent the $10,000 state and local tax deduction cap for individuals made in the Tax Cuts and Jobs Act (TCJA). The proposed regulations issued on Aug. 27, 2018, would apply to any charitable contributions made after that date and would require taxpayers to reduce their federal charitable contribution deduction directly by the amount of state tax credit they receive.

Background

Before the new proposed regs were issued, taxpayers could make charitable contributions to certain state-sponsored programs and receive tax credits on their state tax return. These charitable contributions were also deductible on taxpayer’s federal returns in full.

This treatment was seemingly contradictory to the definition of a charitable contribution. However, prior to the passage of the TCJA, the IRS was not concerned about this. Any state tax credits received would reduce the taxpayer’s state tax liability, and, therefore, the taxpayer would receive a smaller deduction in state taxes paid on their federal return. Thus, permitting a charitable contribution deduction in full for which the taxpayer also receives a state tax credit generally had no effect on a taxpayer’s federal tax liability due to this offset. The character of charitable contributions under these circumstances was deemed to be unbroken.

Why the change

Passed in December of 2017, the TCJA limits an individual’s state and local tax deduction amount to $10,000 beginning in 2018. With this change, taxpayers whose state and local tax expense exceeds $10,000 would not have an adjustment for charitable contributions that produce state tax credits. Since their state tax deduction is already capped, this creates a situation where charitable contributions to these state programs would grant a full federal charitable deduction with no offset for the state tax credit received. Looking at this, the IRS determined transactions under these circumstances circumvent the intent of the new state and local tax cap and create a quid pro quo that violates the definition of a charitable contribution.

Proposed regulations

The proposed regs would end this work around by requiring a reduction in the federal charitable contribution deduction by the amount of state tax credit received. Any state charitable program that provides a tax credit of more than 15 percent of the amount contributed would be affected, regardless of when that program was initially started. If the proposed regulations pass, any contributions made after Aug. 27, 2018, would need to be adjusted for.

Example

Take two popular credits offered by Iowa: The Iowa Endowment credit and the Iowa School Tuition Organizers (STO) credit. Under the proposed regs, if a taxpayer gave $1,000 to Endow Iowa, which produces a 25 percent tax credit, they would receive a $250 credit on their Iowa tax return and a $750 charitable contribution deduction on their federal return. Taxpayers were allowed the full $1,000 federal deduction previously but would now have to reduce the amount by the $250 credit for a net of $750. For the Iowa STO, it’s the same scenario at a 65 percent tax credit. A $1,000 contribution would generate a $650 credit on the Iowa return. Taxpayers would only be allowed a charitable deduction of $350 ($1,000 – $650 credit) on the federal return under the proposed regs. Effectively, the net cost of contributions to these and similar programs will increase.

Relief for businesses

The IRS clarified its position shortly after releasing the proposed regs. Importantly, they stated that business taxpayers can still deduct business-related payments to charities or government entities for which they receive a state tax credit as an ordinary business expense. Taxpayers must be able to show that the payment is directly related to their business and the payment was made with a reasonable expectation of financial return, comparable to the amount contributed.

For more information on the impact of tax reform to your federal and state tax situation, contact your account manager at 888-556-0123 or fill out or form.

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