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Sunday, June 16, 2019

Latest Guidance on SALT Cap and Donations + Notice 2019-12 Safe Harbor

Excerpt from 2018 Form 1040 Schedule A, Itemized Deductions
The $10,000 cap on itemized deductions of state and local taxes led a few states to add new "workarounds" such as offering a credit that would reduce state taxes (where the deduction is limited) and converting it to a federal charitable contribution (which is not limited (well it is, but only when donations exceeds about half of your income)). For example, since 2014, California's College Access Fund takes donations for which the donor gets a 50% credit against their California income tax. On the federal returns that means a charitable contribution for the full amount and a reduced state tax deduction since the credit reduced the donor's state taxes.

Prior to the Tax Cuts and Jobs Act, at least 18 states had these credit donation arrangements with credits up to 100%, mostly for donations for scholarships to private schools (see Sept. 2018 GAO report). The benefits are funding scholarships, shifting tax dollars to private schools rather than only public schools, and providing a tax break to donors who owe alternative minimum tax (AMT).

After the TCJA, Treasury said it would issue regs to limit the benefit of these credit schemes, taking a substance over form approach in the guidance (Notice 2018-63 (8/3/18)). Proposed regulations were issued in late August 2018 (REG-112176-18 (8/27/18)) & IR-2018-172 (8/23/18)) that basically require the donation to be reduced by the state tax credit claimed or available unless that credit was 15% or less of the amount transferred to the state or local government. This treatment applies to donations made after 8/27/18, regardless of when the state/local tax credit regime was created. Treasury Secretary Mnuchin also issued a press release on 8/23 about the regulations and intent.

IRS received over 7,500 comments on the proposed regs. Per the IRS, 70% of the comments favored the approach of the regulations (see IR-2019-109 (6/11/19)). The final regs (TD 9864 (6/13/19)) follow the proposed regs.

The IRS also issued a proposed safe harbor effective starting for 2018 that provides a benefit to a donor receiving a state or local tax credit but who has deductible state and local taxes below the $10,000 deduction cap. Individuals who can benefit and who have already filed can file an amended return. The IRS expects the proposed safe harbor to be added to proposed regulations it will issue on the new $10,000 SALT cap.

I didn't find the notice to be entirely clear, but piecing together how it is described in the preamble to the final regs (TD 9864 (6/13/19)) and the suggested rationale for the safe harbor, I offer the following interpretation and examples.
[assumes both Anne and Ben have itemized deductions greater than standard deduction]
Anne - Donates to state charity and receives 60% state tax credit
Ben - Donates to Red Cross for which regular deduction rules apply
Amount donated
Amount disallowed under §170
Total SALT before state credit
SALT after state credit
Charitable donation allowed
$ 400
Aggregate Schedule A deduction for SALT and donations
Schedule A with the safe harbor
($7,400 + $400 + $600)
(safe harbor n/a)

While it may seem that the Ben is better off than Anne in this example, Anne paid $600 less of state income tax than did Ben. Looking at cash flow, they are in the same situation.

If the individual were already above the SALT cap, treating the amount disallowed as a charitable contribution as a SALT deduction is of no benefit. Thus, the safe harbor is only helpful to an individual below the SALT cap who also donates to a charity that yields a state or local tax credit.
Meanwhile, a lawsuit (No. 18-CV-6427) filed by Connecticut, Maryland, New Jersey and New York in July 2018 has oral argument on June 18, 2019 in the Southern District Court of New York. I don't expect the states will win on their position that the SALT cap is illegal or that it was politically motivated. There are several deduction prohibitions and limitations in the law and political motivation is likely tough to prove.

What do you think?


taxperson said...

In California every recent homeowner will be above the $10k. Prop. 13 and Social Security being tax free (until California changes that law also) will help older residents fall under 10K but then if the house is paid off they will likely take the standard deduction anyway....

Thank you for posting all the details. You are doing great work for the practicing tax community.

21st century taxation (Annette Nellen) said...

Thanks for the comments. Yes, with cutback in several itemized deductions and higher standard deduction, only about 13% itemize today compared to 30% prior to the TCJA. The $10,000 cap is poorly designed. For example, a C corp continues to get full deduction of its state income taxes, but a sole proprietor, partner or S corp shareholder likely won't get a full deduction of the state income taxes on their pass-through business income. I can see putting a limit on property taxes, such as not being able to deduct them on vacation homes, but denial of a deduction that a C corporation can deduct is not good tax policy.