IRS Issues Proposed Regulations on Charitable Contributions and State and Local Tax Credits

Prior to the Tax Cuts and Jobs Act (TCJA), signed into law in December 2017, taxpayers were allowed an itemized deduction for state and local taxes paid without any limit on the amount of such deduction. The TCJA limited the state and local tax deduction, for individuals, to a maximum of $10,000. As a result, some states contemplated the creation of new state charitable funds, the donations to which would qualify for a state tax credit. Since charitable contributions are only limited by a taxpayer’s adjusted gross income, taxpayers that contributed to the state charitable funds, in lieu of paying state income tax, would generally receive a greater federal itemized tax deduction.

Offering state tax credits in exchange for charitable contributions is not a new idea. In fact, 33 states already offer some type of state tax credit for charitable contributions. In an attempt to prevent circumvention of the state and local tax limitation in the TCJA, the IRS recently issued proposed regulations reducing a taxpayer’s charitable contribution deduction when such taxpayer receives or expects to receive a state tax credit for contributions made after Aug. 27, 2018. The proposed regulations contain not only a general rule but also various other rules depending on the type of program and magnitude of benefit.

First, the general rule. Under the proposed regulations, a taxpayer’s charitable deduction is reduced by the amount of any state or local tax credit that the taxpayer receives or expects to receive. For example, John contributes $1,000 to a newly created state charitable fund. In consideration for this contribution, John receives a $500 state tax credit. Under the general rule, John’s charitable deduction must be reduced by the amount of the state tax credit he received ($500). Thus, John is allowed a $500 charitable deduction on his federal tax return. It should be noted that the proposed regulations clarify that the amount of the reduction is the maximum state credit allowable. The IRS is working on a solution in the event that a taxpayer declines the state and local tax credit. However, this solution is not contained in the proposed regulations and the IRS has requested comments regarding such a solution.

If a state program offers a dollar-for-dollar state or local tax deduction for a charitable contribution, such program will not require a reduction in a taxpayer’s charitable deduction. If, on the other hand, the state tax program offers a deduction that exceeds the amount a taxpayer pays, then the taxpayer must reduce the charitable deduction by the excess amount. For example, under the state’s program, Mary is entitled to a $1,000 state tax deduction for a $1,000 contribution. Mary is not required to reduce the charitable deduction on her federal tax return.

The proposed regulations also contain a de minimis provision. If a taxpayer receives a state tax credit that does not exceed 15 percent of the amount contributed, the taxpayer is not required to reduce the charitable deduction. For example, a state program offers a state tax credit for 10 percent of the amount contributed. Susan makes a $1,000 contribution under this program and receives a $100 state tax credit. Susan is allowed a federal charitable deduction of $1,000.

In sum, the IRS is attempting to prevent the circumvention of the state and local tax deduction limitation by states. Unfortunately, there is no grandfathering provision for programs that have been in place for many years. Taxpayers can take advantage of the full charitable deduction for contributions made on or before Aug. 27, 2018.