On August 23, 2018, the Internal Revenue Service issued proposed regulations that reduce the federal tax benefit of charitable contributions to state or local government funds or organizations.
The 2017 federal tax reform legislation, the Tax Cuts and Jobs Act, imposes a $10,000 cap on the annual itemized deduction for state and local taxes paid for tax years 2018 through 2025. This limitation applies to individuals as well as trusts and estates. In response to the limitation, a number of states have passed legislation, or proposed legislation, that would allow taxpayers to make a charitable contribution to designated state or local funds. In return for these designated charitable contributions, the donor would be entitled to claim a state tax credit that could offset the donor’s state income tax liability.
For example, proposed, but not enacted, California legislation would provide an 85% state tax credit to donors for contributions to the Local Schools and Colleges Voluntary Contributions Fund. In addition to the reduction of donor’s state tax liability by claiming the credit, the states expected that the donor would be eligible to claim a federal charitable contribution deduction for the full amount of the contribution. Under this scenario, it was expected that for a $1,000 contribution, the donor would be eligible to claim an $850 state tax credit and a $1,000 federal charitable contribution deduction.
IRS Proposed Regulations
The IRS proposed regulations limit the federal charitable contributions deduction, in most cases, when the donor receives or expects to receive a state or local tax credit in return for the payment. The payment may still be eligible for a federal charitable contribution deduction, but the amount of the federal deduction is reduced by the state or local tax credit received or expected to be received.
For example, if an individual is entitled to receive a state tax credit of $850 in return for a $1,000 payment to a state or local fund, the federal charitable contribution deduction is limited to $150.
The proposed regulations contain a de minimis exception that applies if the state or local tax credit does not exceed 15% of the payment. Under this exception, the federal charitable contribution is not required to be reduced by the amount of the state tax credit.
The proposed regulations apply to contributions by individuals, trusts, and estates made after August 27, 2018. However, the IRS states in their commentary accompanying the proposed regulations that charitable contributions made on or before August 27, 2018 could still be challenged by the IRS.
On September 5, 2018, the IRS clarified that business taxpayers who make business-related payments to charities or governmental entities for which the taxpayers receive state or local tax credits can continue to deduct the payments as business expenses. The business expense deduction is available to any business taxpayer regardless of whether it is doing business as a sole proprietor, partnership or corporation, as long as the payment qualifies as an ordinary and necessary business expense.
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