The much-hyped strategies certain states pursued to help high-income taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. payers avoid the new state and local tax (SALT) deductionThe state and local tax (SALT) deduction permits taxpayers who itemize when filing federal taxes to deduct certain taxes paid to state and local governments. The Tax Cuts and Jobs Act (TCJA) capped it at ,000 per year, consisting of property taxes plus state income or sales taxes, but not both. cap are all for naught. That’s the upshot of newly-issued proposed Treasury regulations on workarounds which sought to recharacterize state and local tax payments as charitable contributions. State-incentivized contributions to charitable organizations will remain highly attractive, but taxpayers won’t be able to claim a federal deduction for the portion of their contribution fully offset by a state credit.
While policymakers in states like New York and New Jersey have claimed that the SALT deduction cap unfairly targets their states, the reality is that the vast majority of taxpayers across the country–including in New York and New Jersey–got a federal tax cut under the Tax Cuts and Jobs Act even with the reduced value of the SALT deduction, which helped pay for rate reductions and other reforms that reduced overall tax liability.
In the proposed regulations, the Treasury Department emphasized the principle of substance over form, advising taxpayers that a payment made in satisfaction of state or local tax liability does not cease to be a tax payment simply because the state chooses to characterize it as a charitable contribution.
The goal of the charitable deduction has always been to give preferential treatment to actual charitable contributions, with guardrails designed to limit its use as a tax avoidance strategy. Since donative intent is difficult to gauge, the IRS has long used simpler mechanisms as proxies, most notably two requirements:
- The amount of any contribution claimed for purposes of the charitable deduction must be reduced by the fair market value of any benefit received by virtue of making the contribution; and
- The amount of any contribution claimed for purposes of the charitable deduction must also be reduced by the amount of any liability assumed by the recipient of that contribution.
The SALT workarounds pursued by a few states faced several arguably insurmountable hurdles. They pretty obviously and intentionally functioned as little more than a recharacterization of tax payments, since the government still got the money (albeit indirectly). Even if we somehow did regard the payment as a charitable contribution, the scheme was likely to fail because the offsetting tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. s were a benefit accruing to the taxpayer and a liability imposed on the recipient of the contribution (the government), which should both serve to reduce the amount claimed under the charitable deduction and thus eliminate the workarounds’ raison d’être.
The Treasury Department could have gone several routes here. It could disallow workarounds purely on grounds of recharacterization, remaining silent on any credits that incentivized contributions to third-party charitable organizations. (Since the revenue doesn’t flow to the government, the payment is not a satisfaction of tax liability.) It could require taxpayers to reduce the amount claimed under the deduction by the amount of any benefit they receive from the recipient, having the effect of disallowing workarounds but sustaining the full deduction for state-incentivized contributions to charitable organizations. Or it could require taxpayers to reduce the amount claimed under the deduction by the amount of any benefit received from any party (including the state) as a consequence of the contribution, with the additional consequence that a deduction could not be claimed at the federal level for the amount of any charitable contribution returned to the taxpayer in the form of a state tax credit.
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Today’s proposed regulations took the third route, holding that all contributions claimed for purposes of the charitable deduction must be reduced by the amount of any corresponding credits received, which renders intentional workarounds worthless and prevents a doubling up under state credits designed to incentivize contributions to nonprofit organizations, though these credits will continue to be highly attractive to taxpayers on their own.
The proposed regulations would continue to allow a full deduction for charitable contributions for which state provide a dollar-for-dollar charitable deduction, but not for those incentivized with a tax credit. Treasury proposes a 15 percent de minimis threshold for credits, so that small credits can be taken without requiring a reduction in the amount claimed under the federal deduction. For more substantial credits, however, only the amount of the contribution in excess of the credit can be deducted.
So, for instance, if you make a $100,000 contribution and receive $75,000 in offsetting tax credits, you can deduct the other $25,000 on your federal tax return—but not the full $100,000.
This is unlikely to be the end of the story for SALT workarounds—though it should be. What these efforts lack in legal merit, they make up for in political positioning. Litigation is likely, though probably futile given the authority the government has in such matters. In the wake of this new guidance, any state wishing to continue its fight will be placing political performance theater over the interests of the taxpayers who have to foot the bill.Share