Charitable giving incentives are receiving collateral damage from a tug of war between the federal treasury and the states over the December 2017 Tax Act’s limitation of the state and local tax (SALT) deduction to $10,000.
In response, some states and municipalities hit on the idea of allowing their taxpayers to replace some of their state and local income taxes with charitable gifts, as the charitable deduction is not subject to an overall cap and is instead tied to a percentage of adjusted gross income (AGI). For example, a state might change its tax laws so that if taxpayers gave to a 501(c)(3) local school foundation, the taxpayers would be given a credit for that gift against their state income or property tax. The same amount would fund the school, albeit through a gift rather than through taxes, and the taxpayers would get an uncapped charitable deduction they could use on their federal income tax returns rather than a capped state and local tax deduction. This idea would work out best for higher-income taxpayers whose state and local tax bills are already over the $10,000 cap but who still have room left under their federal AGI limits for charitable gifts. The IRS promptly pushed back, with a June 2018 notice and August 2018 proposed regulations, which in turn drew over 7700 comments. Nonetheless, those regulations were finalized in June 2019.
The new regulations chose to expand the existing quid pro quo rules for charitable gifts into the area of state tax credits and deductions for charitable gifts. They provide that “the amount of the taxpayer's charitable contribution deduction … is reduced by the amount of any state or local tax credit that the taxpayer receives or expects to receive in consideration for the taxpayer's payment or transfer.” There are two exceptions: (a) a state or local income tax deduction that does not exceed 100% of the fair market value of the property transferred and (b) a state or local tax credit that does not exceed 15% of the fair market value of the property transferred. If the state or local tax benefit is over the threshold, the whole amount is considered a quid pro quo, not just the excess.
Notice 2019-12 Safe Harbor
There is a little bit of good news. Taking the new quid pro quo theory to its logical conclusion, the IRS has issued a safe harbor rule that the amount of the charitable deduction that is lost from the new quid pro quo rule can be treated as a state and local tax payment. That will be helpful to taxpayers who are still under the $10,000 state and local tax deduction limit. However, transfers of property are explicitly outside the safe harbor, so donors can’t make a gift of appreciated property in lieu of state or local taxes and get a state and local tax deduction on their federal income tax return.
No Disclosure Required on Charity’s Gift Receipt
Another bit of good news is that charities will not be required to disclose state and local tax credits on the quid pro quo disclosure required under Code Section 6115. Only quid pro quo benefits provided by the charity must be disclosed. While not specifically mentioned in the regulations, that would also mean that the $10 per contribution penalty for failing to disclose would be not assessable under Code Section 6714. Donors must still reduce their charitable deduction by any quid pro quo tax credit.
A Cloud Over Montana and North Dakota
The new regulations won’t directly affect most planned giving programs. The most common state and local charitable giving incentive, an income tax deduction equal to the amount of the gift, is untouched. However, there are some special programs that may be affected. For example, the states of Montana and North Dakota for many years have been offering 40% tax credits for certain types of planned gifts, and 40% is above the new 15% exemption threshold. Even though those tax credits were established well before the December 2017 Tax Act was introduced in Congress, the final regulations are explicit that there is no grandfather rule.
However, there may still be room for legal argument over the meaning of “in consideration for” in the new regulation, which is defined by reference to the existing quid pro quo regulations: “if, at the time the taxpayer makes the payment to the donee organization, the taxpayer receives or expects to receive goods or services in exchange for that payment.” Are all state and local tax credits “in exchange for” the charitable gift? That is one way to read the new IRS regulation. The donor making the gift (the “quid”) receives the tax credit (the “quo”).
Brave donors willing to fight if the IRS challenges their claim for an unreduced charitable deduction on their federal income tax return can argue that state and local tax incentives for charitable giving of broad applicability are not in their nature a quid pro quo, and a closer connection between the gift and the tax credit is needed for the tax credit to be considered “in exchange for” the gift (a “quid” and a “quo” but no “pro”). For not-so-brave donors, the Montana and North Dakota tax credits are still a great deal – they get the 40% state tax credit for their planned gift on their state return, a 40% deemed state tax payment on their federal return (subject to the $10,000 deduction cap) provided the gift is made in cash, and the remaining 60% as a charitable deduction on their federal return (subject to the AGI limits).
Other Third-Party Benefits Are Next
The final regulations announced that the IRS is looking to issue further new regulations expanding the quid pro quo rules to other types of third-party benefits. What types of benefits that will bring under the quid pro quo rules remains to be seen.
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