New Tax Regulations Limit Deductions for Gifts That Generate State Tax Credits

September 7, 2018

The Treasury Department has proposed new regulations that may hamper numerous state programs offering state income tax credits in return for charitable contributions. Designed to thwart recent state efforts to circumvent new limits on the deductibility of state and local tax (SALT) payments, the regulations also ensnare longstanding state tax credit programs that support education, conservation, poverty relief and other initiatives. 

The 2017 Tax Act imposed a $10,000 cap on the federal income tax deduction for SALT payments. In response, several high-tax states like New York, New Jersey and California enacted programs that offered state tax credits for gifts to certain charities that administer state programs. Those state initiatives would have transformed nondeductible SALT payments into deductible charitable contributions on donors’ federal returns. 

The proposed regulations, which apply to gifts made on or after Aug. 28, 2018, disallow charitable deductions to the extent that the donors receive state tax credits in return (if the credits exceed 15 percent of the contribution). For example, a $1,000 donor who receives a 60 percent state tax credit could claim a federal charitable contribution deduction for only $400. In contrast, a donor who receives only a 10 percent state tax credit could deduct the entire $1,000. 

The new regulations affect only contributions from individuals, trusts and decedents’ estates. The IRS has confirmed that a business may claim its entire contribution as a business expense despite any state tax credits received.  

Although aimed at states’ plans to help their residents avoid the new SALT limit, these proposed regulations do not affect just the new state workaround programs. As proposed, they also ensnare any existing state initiative that offers tax credits to encourage contributions to support education, conservation, social services or other state priorities, and they substantially reduce the federal tax benefits associated with those initiatives. 

Many states have longstanding programs that offer tax credits in return for contributions to charity. For example, Virginia’s Neighborhood Assistance Program and Education Improvement Scholarship Program offer taxpayers state income tax credits equal to 65 percent of their contributions to certain charities. Virginia donors also can claim state income tax credits for 40 percent of the value of land or easements donated for conservation purposes. Under the proposed regulations, donors may receive a federal charitable deduction for only 35 percent of their contributions to the Neighborhood Assistance Program and the Education Improvement Scholarship Program. Similarly, donors who contribute land or conservation easements may deduct only 60 percent of the value of their contribution.

The regulations apply only to state tax credits and do not affect a donor’s right to claim dollar-for-dollar state charitable contribution deductions. They also do not affect programs that generate state tax credits by means other than charitable contributions, such as tax credits for rehabilitation of historic structures.

These regulations represent a substantial departure from earlier IRS positions and court rulings, which generally allowed full federal deductions for charitable contributions that generated state tax credits. Prior donors therefore were able to use their entire charitable contribution to reduce both state and federal income taxes. 

The IRS has requested comments on these proposed regulations. It plans to hold a public hearing Nov. 5, 2018, to discuss the issues raised. Charities, donors and tax advisors should be aware that, although these are only proposed regulations, they apply to gifts made on or after Aug. 28, 2018, until and unless the Treasury Department rescinds the rules or issues final regulations.

Charities should discuss these changes with their tax advisors, as they may need to disclose the value of state tax credits as a quid pro quo on receipts provided to donors. Advisors and charities in states with tax credit initiatives should be sure to assess the implications of these changes for larger donors.