The clock is ticking for taxpayers who want to contribute to state tax credit programs and nab a charitable deduction to boot on their federal return.
The IRS and Treasury's newly released proposed regulations block blue state attempts to bypass the new $10,000 limit on state and local tax deductions, also known as SALT.
This limit was imposed by the Tax Cuts and Jobs Act, an overhaul of the tax code that was passed last year.
Though the new guidance from Treasury and the IRS is a proposal at this point, it has an effective date of Aug. 27 and is intended to apply to transactions made after then.
"In a perverse situation, you donate $100 and you get back $137 in the form of state tax credits and deductions."That means that whether you're contributing to a state-established charitable fund in New York or New Jersey, or you're giving money to a private school scholarship program in Alabama or South Carolina, you may no longer be able to claim a charitable deduction on your federal return if that state gives you a tax credit exceeding 15 percent.
"There is an opportunity to avail yourself of the existing regimes before Aug. 27," said Daniel Rosen, a partner in the North America tax practice group at Baker & McKenzie.
"When the regulations become final, even in the worst case scenario that they are retroactive to the 27th, they won't apply to those prior contributions," he said.
"But it doesn't mean that the IRS won't try to attack those contributions under other principles of law," Rosen said.
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In particular, the proposed regulation says that if a taxpayer receives a benefit — for instance, as a state or local tax credit — for making a charitable contribution, then that taxpayer must reduce the amount claimed as a charitable deduction on his or her federal return.
If the tax credit received is less than 15 percent, then the taxpayer would get the full charitable deduction.
"Imagine that you made a $100,000 contribution and you receive a 75 percent state tax credit," said Jared Walczak, a senior policy analyst at the Tax Foundation. "Your contribution cost is only $25,000 and the state is giving you back $75,000."
"You can take the $25,000 as a charitable deduction on your federal tax return, but not the $100,000," he said.
Blue statesNew York, New Jersey and Connecticut have passed laws that would allow their residents to step around the SALT cap.
California, which is home to the one of the highest income tax rates in the country, has legislation for a workaround under consideration.
One of the strategies higher-tax states have green-lighted includes allowing municipalities to establish charitable funds for contributions from taxpayers.
These residents would then be able to claim a state tax credit — and they may claim this contribution as a charitable deduction on their federal returns if they itemize.
The IRS proposal would largely bar that.
Red states
Earlier this year, a group of tax law academics pointed out more than 100 programs in 33 states offering tax credits in return for charitable donations.
There are 18 states with private school voucher tax credits, including programs in Arizona, Alabama and South Carolina. A number of them offer credits to contributing taxpayers on a dollar-for-dollar basis.
"In a perverse situation, you donate $100 and you get back $137 in the form of state tax credits and deductions," said Carl Davis, research director at the Institute on Taxation and Economic Policy.
Lesley Searcy, executive director of the Alabama Opportunity Scholarship Fund, said their benefactors would feel the effects of the proposed rule.
"The proposed rules issued yesterday are disappointing," she said. "The IRS states that only a 'small percent' of donors nationally will be affected by the rule, but many of those donors are the very ones who support our students."
"We are certainly hoping that a compromise is reached that includes a carve-out for preexisting scholarship programs like the Alabama Opportunity Scholarship Fund," she said. "The future of thousands of children from low-income families depends on it."
Sensible givingAs the proposed rule is written, contributions made after Aug. 27 would be subject to the new limitations.
Gifts made prior to that date might be fair game for you.
"It appears that if you made the gift already, you can take the full deduction," said Tim Steffen, CPA and director of advanced planning at Robert W. Baird & Co.
"But they leave open the possibility that they can go back and retroactively apply the regulation," he said.
Indeed, clients have already expressed interest in what they can do to get ahead of the proposed regulation, said Rosen of Baker & McKenzie.
Be aware that while the IRS has a ways to go before finalizing its regulation — the guidance will go into a comment period and there could be a hearing before the final version is hammered out — you still run the risk of a challenge from the IRS on the charitable deductions you claim on your federal return, Rosen said.
"People will be cautious about making contribution to the funds, given the IRS and Treasury position," he said.
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