State and local governments and taxpayers beware - the IRS has its eyes on recent proposals designed to circumvent the new $10,000 limit on state and local tax deductions imposed by the Tax Cuts and Jobs Act (TCJA). For the time being, you may want to hold off on making contributions to these newly established state and local tax credit funds if you expect to receive a federal charitable contribution deduction in return. Here's why...
Yesterday, the IRS issued a warning shot with Notice 2018-54, indicating it intends to propose regulations addressing whether transfers to these new state programs qualify as deductible charitable contributions. We anticipate the focus will be whether donative intent exists at the time the transfer is made to the state fund, given a corresponding state or local tax credit is received in exchange. Donative intent is required for a charitable contribution to be deductible and is considered to exist only when the contribution is voluntary.
Connecticut, New York, and New Jersey, among others, have all enacted programs that would allow you to make transfers to funds controlled by the state or local governments, or other designated agencies, in exchange for credits against your state and local taxes. The aim of these proposals is to allow you to satisfy your state and local tax liabilities while also obtaining a charitable contribution deduction for federal tax purposes. Since charitable contribution deductions were not limited by the TCJA, the new programs are effectively designed to circumvent the new limitation on state and local tax deductions for individuals.
Loyal D&S blog followers, if these proposed state programs sound eerily familiar to you, it may be because the Pennsylvania Education Improvement Tax Credit (EITC) and Opportunity Scholarship Tax Credit (OSTC) programs function in a similar fashion, though they've been around for years before the TCJA. However, it’s possible these programs may remain unaffected by the forthcoming regulations - more on that below.
A thoughtful analysis for the allowance of a charitable contribution deduction in connection with these types of programs was performed by a group of academics and economists in a long paper, titled Federal Income Tax Treatment of Charitable Contributions Entitling Donor to a State Tax Credit,earlier this year. Their analysis, which concluded the payments should qualify as deductible charitable contributions, is based upon a Chief Counsel Advice from 2011 (CCA 201105010) that is not considered precedential. For the non-tax geek, precedential means you can take a position on a tax return based upon it. Similarly, you can't take a contrary position on a tax return without disclosure or risk paying a penalty. Once the IRS issues the proposed regulations, they will be considered precedential, so they will override anything outlined in the CCA.
While we don't currently know what the IRS is thinking and how they plan to attack these programs, we have some thoughts of our own:
It's possible programs in existence prior to the TCJA, such as the PA EITC and OSCT programs, may remain safe since they were not enacted in response to the legislation. However, some of our tax purists disagree, proclaiming the law should apply equally to all programs regardless of when or why they were enacted.
Some also believe programs like the PA EITC and OSCT will continue to qualify for a charitable contribution deduction because they do not support general state functions. While state credits are received in exchange for the contributions, the funds are directed to organizations that do not receive state tax dollars, so it's possible they could be considered voluntary.
Finally, instead of a full disallowance, could we see the IRS require charitable contribution deductions to be reduced by the state or local tax benefit received in exchange for the contribution? This quid pro quo rationale would be the same reason why the value of your dinner at the gala reduces your charitable contribution deduction.
At this point, the IRS has made it clear these types of programs will fall under scrutiny but nor what the ultimate impact will be on new or pre-TCJA programs. In the end, regardless of the Federal income tax benefit, many taxpayers may prefer to send their state tax dollars to a state credit program. Programs like the PA EITC and OSCT, where the funds can be directed to specific schools or scholarship programs instead of the PA Department of Revenue to be spent however the government decides, are perfect examples.
The Tax Warriors® at Drucker & Scaccetti will keep you posted on future guidance released by the IRS regarding the federal deductibility of contributions to state funds. In the meantime, programs such as the PA EITC and OSTC continue to have value beyond their specific tax benefits.