Nice Try, States! IRS Shuts down Attempted Bypass of Cap on State and Local Tax Deduction

To the dismay of high-tax states like New York and California, the Tax Cut and Jobs Act (TCJA) established a $10,000 limit on the amount of combined state and local taxes an individual can deduct on their federal income tax return. Several of those states attempted to help their residents circumvent the limit using charitable organizations: Contribute to the organization, get a credit against your state taxes due, then deduct the amount on your federal return as a charitable contribution to get around the state tax deduction cap.

Unsurprisingly, the Internal Revenue Service (IRS) quickly promised to issue rules putting an end to the practice. Those rules were published in the Federal Register on June 13, 2019.

The upshot is that if taxpayers receive a state tax credit for a charitable contribution, that credit is considered a quid pro quo and is thus not deductible for federal tax purposes. The credit amount is deductible as a state tax payment, though, up to the $10,000 cap (Notice 2019-12). Note that the same rules apply to trusts and estates.

To illustrate:  A taxpayer who owes $15,000 in combined state property and income taxes makes a payment of $10,000 to the state and $5,000 to a not-for-profit organization, receiving a $5,000 credit against state taxes due. The intent, for the federal tax return, is to deduct $10,000 from income as state taxes paid and $5,000 as a charitable contribution. The new rules disallow that charitable deduction because the taxpayer received value in exchange for it, under the doctrine of quid pro quo.

However, if the taxpayer made a $5,000 contribution but received a $4,000 tax credit, the $1,000 difference would be deductible as a charitable contribution.  

Exceptions

There are a couple of exceptions allowed: if the credit is worth 15% or less of the contribution, then the full amount may be deducted. Second, a state or local deduction (not credit) does not reduce the amount deductible from federal taxes, as long as the state or local deduction doesn’t exceed the amount of the contribution.

Need guidance?

If you would like some help figuring out how these new rules will affect you, contact us. Weaver’s tax professionals can help you understand the implications and plan for the coming year.