Synopsis of New IRS Rules on SALT Deduction Cap Charitable Workaround

June 11, 2019

This afternoon, the Department of the Treasury and the Internal Revenue Service issued long-anticipated new rules and guidance on the charitable contribution SALT deduction workaround. They’re much what we expected, and I’ll save a detailed analysis for a later date, but for now, here’s a basic synopsis of what the regulations establish.

  1. Charitable deductions must be reduced by the value of any tax credit received.

    This is an application of the quid pro quo doctrine, under which a transfer only constitutes a charitable contribution to the extent that it is unrequited. If you expect to receive a benefit from a contribution, then it is not truly charitable (and ineligible for the deduction), or at least that portion of your contribution isn’t.

    This isn’t just about tax credits. If your contribution entitles you to attend a gala or awards you a book or tote bag, then the contribution you can claim for purposes of the charitable deduction is reduced by the value of those benefits. What the IRS clearly (and unsurprisingly) establishes here is that it works the same way for tax credits. If you receive a tax credit worth 60 percent of the amount you contribute to a scholarship organization, free clinic, or other recipient, you can only claim the remaining 40 percent of the contribution under the charitable deduction.

  2. The rest of the contribution is functionally treated as taxes paid.

    There’s another relevant doctrine here, the idea of substance over form. The IRS is far more concerned with the essence of a transaction than what it’s called or how it’s framed. If a payment is made in satisfaction of tax liability, the IRS is likely to think it’s a tax payment even if it’s called a charitable gift—whether to a state-created “charity” designed specifically as a tax avoidance mechanism or to a genuine charity with a resulting credit.

    This is part of the reason why workarounds that purport to offer a net tax benefit fail, but it also means that the residual amount can be treated as taxes paid under Section 164 (rather than charitable contributions under Section 170(c)) for purposes of the federal tax deduction. Consequently, if someone—a corporation or individual—makes a contribution that yields a 60 percent tax credit, they can claim 40 percent of its value under the charitable deduction and 60 percent of its value under the state and local tax deduction, subject (for individuals) to the $10,000 cap on the state and local tax deduction.

  3. As a result, if states want to fully subsidize charitable contributions, they can, but they can’t enable tax arbitrage.

    Imagine a corporation contemplating a $100,000 contribution to a qualifying nonprofit which would yield a 100 percent credit against their state tax liability. If they don’t make the contribution, they get a $100,000 federal tax deduction for state and local taxes paid. If they do make the contribution, they get a $100,000 federal tax deduction for their charitable contribution. The federal tax code was agnostic to their choice; it was entirely up to the state’s willingness to incentivize the contribution.

    This becomes more of an issue under the new federal law, of course, because it potentially allows recharacterization to avoid the $10,000 cap on the state and local tax deduction for individuals, a cap which does not apply to corporations (since business expenses are generally deductible). Any rule which cracked down on efforts to turn a profit on tax arbitrage—a rule the IRS had ample authority to make—ran the risk of capturing activity outside that scope. Suddenly, instead of an indifferent choice between two deductions, donors had the potential to be worse off by making the state-incentivized contribution.

    The new rule and guidance clarify this matter through the interaction of the two deductions and the applicability of both quid pro quo and substance over form. The rule prevents double-dipping without penalizing the decision to make a state-incentivized contribution.

The new rule has complexities not discussed here, will no doubt spawn significant further commentary, and merits much more detailed analysis, but this, at least, is a first pass at what it seeks to accomplish.

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A tax deduction is a provision that reduces taxable income. A standard deduction is a single deduction at a fixed amount. Itemized deductions are popular among higher-income taxpayers who often have significant deductible expenses, such as state/local taxes paid, mortgage interest, and charitable contributions.

A 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.