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Proposed Federal SALT Rules Would Close Private School Donation Strategy

POSTED ON Aug. 28, 2018
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The IRS’s proposed rules addressing workarounds to the cap on state and local tax deductions would also shut down preexisting mechanisms allowing taxpayers to make a profit off ostensibly charitable donations to private schools.

This is true of the rules (REG-112176-18) as drafted, several state tax experts said August 24, despite statements by Treasury Secretary Steven Mnuchin and House Ways and Means Committee Chair Kevin Brady, R-Texas, downplaying the impact on state school voucher programs in particular. 

“If I were a red state government official, I might be very mad,” said University of Iowa law professor Andy Grewal. “I would have had a good game going and the IRS was willing to let me play. But then the blue states got involved (on a bigger scale) and the IRS took away everyone’s game pieces.”

Bruce Ely of Bradley Arant Boult Cummings LLP, who represents several scholarship-granting organizations in Alabama and Florida, said in a post that he is disappointed Treasury “didn't heed the pleas of longstanding tax credit scholarship organizations in 18 states” when issuing the proposed rules.

According to Treasury and the IRS, the proposed regs initially were in response to state attempts to circumvent the $10,000 SALT cap imposed by the Tax Cuts and Jobs Act (P.L. 115-97). But the proposed rules “are based on longstanding federal tax law principles, which apply equally to taxpayers regardless of whether they are participating in a new state and local tax credit program or a preexisting one,” the IRS and Treasury said in the proposed rules. 

“They apparently view these totally different organizations, formed long before the TCJA, as mere collateral damage,” Ely said. “This debate is far from over.”

Proposed Rules

Several states tried to circumvent the $10,000 cap on SALT deductions in IRC section 164 by enacting programs to allow individuals to make payments in lieu of taxes to a variety of government-operated public purpose foundations. This in theory would allow taxpayers to deduct those payments under IRC section 170 as charitable contributions for federal income tax purposes while simultaneously satisfying their SALT liabilities.

In the proposed regs, the IRS and Treasury said that when a taxpayer receives a state credit in return for a payment to an entity listed in section 170(c), which includes government and private charities, that tax benefit constitutes a quid pro quo; the individual must reduce the charitable deduction by the amount of any state or local credit received for the donation. Exceptions are provided for dollar-for-dollar state tax deductions and for tax credits of no more than 15 percent of the payment amount or of the fair market value of the property transferred.

Treasury and the IRS said that although deductions could be considered quid pro quo benefits in the same manner, sound policy considerations warrant making an exception to quid pro quo principles in the case of dollar-for-dollar SALT deductions. “Because the benefit of a dollar-for-dollar deduction is limited to the taxpayer’s state and local marginal rate, the risk of deductions being used to circumvent section 164(b)(6) is comparatively low,” the proposed regs say.

Thus, the proposed rules allow taxpayers to disregard dollar-for-dollar SALT deductions. But if the individual receives a SALT deduction that exceeds either the amount of the payment or the FMV of the property transferred, the individual’s charitable contribution deduction must be reduced.

Preexisting ‘Shelters’

Peter Faber of McDermott Will & Emery described the “wonderful tax shelter opportunity” available when an individual receives both a full state income tax credit for a charitable contribution — whether to a private organization or to a government foundation — and a federal tax deduction for the same amount.

“If a person gave $1,000 to charity and got a $1,000 credit against his state income tax for the ‘contribution,’ the contribution would cost him nothing,” Faber said. “If, in addition, he got a federal tax deduction for the $1,000, he would actually make money — the federal tax savings on the $1,000 deduction — by giving money away.”

According to Carl Davis of the Institute on Taxation and Economic Policy (ITEP), private school voucher programs that provide overly generous state tax credits for the donations have been abused as profitable tax shelters. 

“The IRS deserves a lot of praise for resisting calls from the private school lobby to include a special carveout for their 50 to 100 percent tax credits,” Davis told Tax Notes. “Those credits have been widely used as SALT cap dodges,” he added. According to ITEP, financial advisers in red states have been touting the ability of their existing programs to help their residents avoid losing their SALT deductions.

Davis clarified that private school credit programs aren't going to disappear. “But if these regulations are implemented, so-called donors won’t be able to use them to pad their own bank accounts anymore.”

Jared Walczak of the Tax Foundation agreed that existing state credit programs will continue to offer a generous subsidy for charitable contributions.

“The proposed regulations would eliminate the use of existing state tax credits as a tax arbitrage strategy, but they would still be extremely attractive to taxpayers who wish to contribute to causes they care about for pennies on the dollar,” Walczak said.

Consider, for instance, an individual’s $10,000 contribution to a nonprofit, for which the individual gets an 80 percent state tax credit. “Your state tax liability is reduced by $8,000, and you can deduct the residual $2,000 from federal taxable income,” Walczak said. He added that at the top marginal rate, that individual would yield a federal tax savings of up to $740. 

“That means you can direct $10,000 to a cause you support at a personal cost of only $1,260, which is a great deal,” Walczak said. “What you can’t do is turn a profit off the transaction by getting $8,000 back from the state and then claiming the full $10,000 contribution under the federal charitable deduction.”

Walczak added that only alternative minimum tax filers previously had any such arbitrage opportunity, "so for most taxpayers, these existing tax credits are just as generous under the proposed regulations as they were last year.”

Darien Shanske, a law professor at the University of California, Davis, is one of the authors of a research paper widely circulated by government officials to justify newly enacted SALT workarounds in New York, New Jersey, Connecticut, and Oregon. The paper summarizes current federal income tax treatment of charitable contributions in which the donor receives a state tax credit, and it documents widespread state use of such credits generally to encourage private donations to a wide range of activities.

In his initial thoughts on the proposed regulations, Shanske opened by saying that the IRS and Treasury deserve credit for the approach they wound up taking.

“These proposed regulations take a relatively principled position, namely that all state and local tax credits should count toward reducing the value of donations under IRC section 170,” Shanske said. He added that many commentators have suggested ad hoc approaches — such as distinguishing between government and nongovernment foundations — to shield preexisting programs, and that Treasury and the IRS initially had indicated they would rely on the substance-over-form doctrine.

Shanske noted that both Mnuchin and Brady seem sympathetic to the preexisting charities whose programs will also be affected by this new federal treatment of the value of state credits. “This means that these ad hoc distinctions and non-appropriate doctrines may yet reappear in the final regulation,” he said.

“Instead of these weaker distinctions, the IRS relied on the notion of a quid pro quo and argued, essentially, that state credits constitute a ‘quo,’” Shanske added. He said he appreciated that the IRS and Treasury were forthright in acknowledging that existing precedent and practice — though sparse — indicated that a state tax credit does not constitute the kind of transfer of money that requires that the value of the federal donation be reduced.

One important question, however, is what warranted this change of course, Shanske said. Treasury and the IRS had explained in May, in Notice 2018-54, that the primary reason for the proposed regulations was the advent of the SALT cap.

“Before the SALT cap, it did not matter if a taxpayer characterized a payment as a charitable donation or state tax payment, because an itemizer could deduct either,” Shanske said. “With the advent of the cap, matters are different and hence the change. Yet there was one group of people for whom charitable donations were deductible, but state tax payments were not — taxpayers subject to the AMT.” Shanske said his impression is that these were the taxpayers particularly targeted by these programs.

Further, Shanske said he doubted that participants in the preexisting state programs would derive much comfort from the data in the proposed rules and referred to by Mnuchin indicating that few taxpayers would be affected by the regulations.

“Of course, that is true — but that does not mean that these programs do not rely on the small number of taxpayers that contributed to their causes and not others because of the particular tax benefits they receive on account of those donors being subject to the AMT,” Shanske said.

Shanske also noted a "curious coincidence." The proposed rules observe that there are about 5 percent of taxpayers who will itemize and have SALT deductions above the new cap. The Tax Policy Center, meanwhile, estimates that about 5 percent of taxpayers were subject to the AMT in 2017. 

Taken together, it is reasonable to ask if the IRS sufficiently justified its change of approach, Shanske said, given how many taxpayers were already potentially operating in the asymmetric IRC section 164/170 regime, and with more than 100 programs to choose from in 30 states. “This question as to justification implicates contested administrative law doctrines on top of everything else, and so will need to wait another day,” he said.

“One thing is for certain, to my mind anyway, and that is to the extent the IRS sticks to a principled position as to all credits, the stronger a position it will have,” Shanske said.