In a Notice and accompanying News Release, IRS has informed taxpayers that it intends to propose regs addressing the federal income tax treatment of certain payments made by taxpayers to state-established “charitable funds” for which they receive a credit against their state and local taxes—essentially, a workaround adopted by a number of states to avoid the new limits on the state and local tax (SALT) deduction. In general, IRS indicated that the characterization of these payments would be determined under the Code, informed by substance-over-form principles, and not the label assigned by the state.

Background—deductions for state and local taxes and charitable contributions. For tax years beginning after 2017 and before 2026, the Tax Cuts and Jobs Act amended the tax code to limit individual annual SALT deductions to a maximum of $10,000, with no carryover for taxes paid in excess of that amount. The SALT deduction limit doesn’t apply to taxes paid in connection with a trade or business or in connection with the production of income. As a result of this change, many taxpayers will not get a full federal income tax deduction for their payments of state and local taxes.

While federal law limits the deduction for an individual’s charitable contributions, the limits are generally much higher than $10,000, and there is a carryover of charitable contributions that exceed the charitable deduction limits.

States respond. Almost immediately after the TCJA’s passage, certain state legislatures—specifically, those of high-tax states—began looking for ways to mitigate the effect of the new SALT deduction limit for their residents.

A number have states have already implemented workarounds to the deduction limit. For example, New York established new “charitable gifts trust funds” to which taxpayers can make deductible contributions and claim a tax credit equal to 85% of the donation. Similarly, New Jersey enacted legislation that permits localities to establish charitable funds to which taxpayers can contribute and receive a 90% New Jersey property tax credit. California and Connecticut are among the other states that have been weighing similar options.

Forthcoming regs. In Notice 2018-54, IRS stated that it intends to propose regs addressing the federal income tax treatment of transfers described above—i.e., transfers to funds controlled by state and local governments (or other state-specified transferees) that the transferor can treat in whole or in part as satisfying state and local tax obligations.

The proposed regs will:


  1. “Make clear” that the requirements of the Code, informed by substance-over-form principles (see below), govern the federal income tax treatment of such transfers; and
  2. Assist taxpayers in “understanding the relationship between the federal charitable contribution deduction and the new statutory limitation” on the SALT deduction.

Substance over form is a judicial doctrine in which a court looks to the objective economic realities of a transaction rather than to the particular form the parties employed. In essence, the formalisms of a transaction are disregarded, and the substance is examined in order to determine its true nature.


Observation: The implication of IRS’s reference to the substance over form doctrine is likely that the formal mechanisms for implementing the State workarounds—e.g., charitable contributions to “charitable gifts trust funds”—will not dictate their tax treatment. That is to say, IRS will not recognize a charitable contribution deduction that is a disguised SALT deduction.


Observation: While the Notice only mentions workarounds involving transfers to state-controlled funds, another type of workaround has been enacted, and while others have been proposed. In addition to the “charitable gifts trust funds” described above, New York also created a new “employer compensation expense tax” that essentially converts employee income taxes to employer payroll taxes. IRS stated that it is “continuing to monitor other legislative proposals” to “ensure that federal law controls the characterization of deductions for federal income tax filings.”

For more information on how these regulations affect your business, contact Larson & Company today.

Source:  Thomson Reuters Checkpoint Newsstand 5/24/18