Written by: Jeff Senney, Tax and Business Law Attorney
In Notice 2018-54, the IRS informed taxpayers that it intends to propose regulations which address the federal income tax treatment of tax deduction payments made by taxpayers to certain state-established “charitable funds.” These funds were created by a number of states to help taxpayers avoid the new income tax limits on deduction of state and local taxes (“SALT”). The IRS said in the Notice that the characterization of payments to these funds would be determined based on substance-over-form principles, and not merely the label assigned to such funds or payments by the state.
For tax years beginning after 2017 (and before 2026), the Tax Cuts and Jobs Act (TCJA) amended IRC section 164 to limit individual annual SALT deductions to a maximum of $10,000, with no carryover for taxes paid in excess of that amount. As a result of this change, many taxpayers cannot get a full federal income tax deduction for their SALT payments.
While IRC Section 170 limits the deduction for an individual’s charitable contributions, the limits are generally much higher than $10,000, and carryover of contributions that exceed the charitable deduction limits is permitted.
Following enactment of TCJA, certain states, especially high-tax states, started investigating ways to eliminate or mitigate the effect of the new SALT deduction limits.
Several states have now established special “charitable funds” to which taxpayers can contribute monies and claim a tax credit equal to a percentage of the amount contributed. For example, New York established new charitable fund to which taxpayers can make deductible contributions and claim a state tax credit equal to 85% of the donation. New Jersey passed legislation under which localities can establish charitable funds to which taxpayers can contribute and receive a 90% New Jersey property tax credit. Legislation has been introduced in California to establish a charitable fund to which taxpayers could contribute and receive a 100% deduction against state and local taxes. Other states are currently evaluating their alternatives.
In Notice 2018-54, the IRS stated that it intends to propose regulations addressing the federal income tax treatment of the payments made by taxpayers to these “charitable funds.”
The IRS indicates that the proposed regulations will: (1) clarify that substance-over-form principles will govern the federal income tax treatment of such payments; and (2) assist taxpayers in understanding the relationship between the federal charitable contribution deduction and the new limits on the SALT deduction.
Substance over form is a judicial doctrine in which a court looks to the economic realities of a transaction rather than to the particular form the parties employed. In general, the form of the transaction is disregarded, and the substance is examined in order to determine the true nature of the transaction. In other words, the IRS will not recognize a charitable contribution deduction that is really a disguised SALT deduction.
The Notice only specifically addresses payments to charitable funds established by states to avoid the new SALT deduction limits. But the IRS is aware that other work-around arrangements are being proposed by certain states. For example, New York has created a new “employer compensation expense tax” that essentially converts employee income taxes into employer payroll taxes. The IRS indicates that it is “continuing to monitor other legislative proposals” to “ensure that federal law controls the characterization of deductions for federal income tax filings.”
If you would like to know more about the SALT deduction limits, various SALT deduction limit work arounds proposed by the states or any other aspect of state or federal income tax law, please call or contact one of our business or tax attorneys at 937-223-1130 or firstname.lastname@example.org.