Tax professionals are avoiding state-devised charitable programs intended as state and local tax deduction cap workarounds — fearing that clients who use them to claim state credits and the federal deduction for donations made after an IRS cutoff date might open themselves up to audits and penalties.
“I would say that a majority of the CPAs around the country are taking a step back” in light of proposed IRS regs that would bar such workarounds to the Tax Cuts and Jobs Act’s $10,000 cap on SALT deductions, said Michael M. Eisenberg, a California CPA with Squar Milner. “They’re explaining to the client what has happened and giving their opinion, which is: ‘Let’s see if there are other ways to handle donations.’”
The workarounds were introduced by lawmakers in some high-tax states seeking to mitigate the SALT cap’s impact on high earners, who suddenly could not deduct much of their state tax burdens on their federal returns.
Several states — including New York, New Jersey, and Oregon — sought to circumvent the cap by creating or expanding tax credit programs that allow taxpayers to donate to a state-supported cause for a state tax credit, then count the full donation against their federal income tax liability. The IRS made good on its promise to block that tactic, releasing proposed rules in August 2018 that would reduce the charitable deduction allowed by the amount of state tax credits received for credits that exceed 15 percent of the value of the donation.
The proposed regs would affect both SALT cap workarounds approved in 2018 and, more controversially, existing state programs granting taxpayers credits in return for donations — for example, to support private school tuition funds — that taxpayers and professionals have long used to reduce both state and federal liabilities.
Complicating matters, the proposed regs state that the new restriction on the charitable deduction would apply for donations “after August 27,” 2018, which has been read as indicating that donations made before that date aren’t subject to the restriction.
Tax Preparers Back Away
The regs have not been finalized and are likely to be challenged by some states. In the meantime, they have complicated matters for tax preparers, most of whom say they’re planning to comply with the draft rules as written and are generally steering taxpayers away from attempting to claim both state tax credits and the full federal charitable deduction, at least for donations made after August 27, 2018.
“No one wants to take the risk,” said Kathleen K. Wright of Golden Gate University. Wright noted that professionals could face penalties if they disregard the IRS’s edict. Despite initial interest in the much-publicized SALT workarounds, CPAs and other tax professionals are “not interested in this anymore,” she said.
Susan High, president of the Oregon Association of Tax Consultants’ board of directors, said tax preparers in her state have been generally informed about the IRS regs through continuing education. Lisa Lewis, a CPA and editor of the TurboTax Blog for Intuit Inc., said the company has reprogrammed its tax software to reflect the draft rules’ position.
“Our New York state product . . . will allow users to take the deduction for the New York state charitable gifts trust fund . . . but on their federal [return] they won’t be able to take the federal deduction” for the same donation amount, Lewis said. The company has also included “easy-to-understand explanations” of changes, including the proposed regs, she added.
Nathan Rigney of the Tax Institute at H&R Block said his group has worked to educate its tax professionals and clients about the new federal deduction rules and other TCJA-related changes.
“We want to make sure people are as informed as possible,” Rigney said, noting that the company’s software contains information “about charitable contributions and the new guidance.”
Tax professionals anticipate that some taxpayers will erroneously try to claim both state credits and a full federal deduction in violation of the proposed regs, along with other errors caused by confusion regarding the TCJA’s changes. “There’s still people who ask about income averaging” from before the 1986 reform, High said, adding that “a change like [the TCJA] is huge, and there’ll be a lot of confusion.”
Wright predicted that the IRS will see numerous “innocent mistakes” regarding the charitable deduction. How many the IRS catches and “how accommodating the agency will be remain to be seen,” she added.
One potential saving grace, according to Rigney, is that the number of taxpayers seeking to circumvent the SALT cap may be limited, since the authors of the Treasury regs predict that only a small percent would have benefited from charitable SALT cap workarounds anyway.
The Cutoff Date
A key question for professionals is how safe it is to claim credits and a full deduction for donations made before August 27, 2018. Like many other tax experts, Rigney said his interpretation is that the proposed regulations seem to enable people to claim both a state tax credit and a full federal deduction for a donation if they have records to show it was made before that date. But Wright said the IRS’s announcement is unusual, noting that regulations are often retroactively effective to the enactment date of the code section they relate to, whereas the August 27 effective date of the proposed regs is four days after the August 23 release date.
Philip London, a New York CPA with Wiss & Co. LLP in New York, said he is leaning toward treating contributions made before August 27, 2018, as exempt from the proposed regs, but noted that there’s still room for interpretation.
“My thought is, it’s clear that after that date, you’re limited . . . that’s 100 percent clear, black and white,” London said. “Prior to that date, there’s nothing stopping them from taking the position that a quid quo pro would reduce your contribution. But my thought on it is, if they were going to do that, they would have said [the rules are effective] from the date of enactment” of the TCJA.
London said he expects taxpayers in New York to have sought to take advantage of the state’s SALT cap workaround for donations made before August 27, 2018. “In New York, you hit that $10,000 cap pretty quickly” if you’re a high earner, particularly in New York City, he said. “I think that if a taxpayer made the contribution prior to the effective date . . . they probably made that in anticipation of claiming the full amount.”
Taxpayers seeking to claim state credits and the full deduction for donations made before August 27, 2018 — whether as part of a new SALT cap workaround or a preexisting state tax credit program such as the Oregon Cultural Trust or Arizona’s school tuition program — will need to be able to prove the date of their donations. But there are still risks.
“The approach I’d take is explaining to the client, ‘these are the rules up until August 26, and this kind of a program was in fact deemed a solid program’” before the IRS released the proposed regs, Eisenberg said. “But here’s the caveat — the tax return won’t show when that donation was made. The IRS may just decide to audit the return to confirm the date, [and] once they do that, that is going to lead them down that merry path” of scrutinizing the return.
Although taxpayers will likely avoid challenging the IRS on the proposed rules, Dennis Ventry Jr. of the University of California, Davis, said court cases and the agency’s previous guidance supporting the position (that tax credits received in return for donations don’t require a reduction in donors’ federal charitable deduction for those contributions) could be argued to represent a competing substantial authority. A taxpayer could try to assert that a reasonable basis exists for claiming the full deduction and disclose that decision to the IRS on their return, but Ventry said that assertion would “basically [flag the return] for the IRS to challenge.”
Wright agreed that challenging the IRS’s position would be risky. “I don’t think I’d sign a return” if a client tried to claim a full deduction, she said.
Eisenberg said he’s preparing to advise taxpayers to look at other ways to plan around the new limits on deductions. Noting that multiple TCJA provisions, including the SALT cap, are scheduled to expire in 2025, Eisenberg said that in the meantime, he and other tax professionals may propose “bunching” donations and other deductible payments, such as those for medical expenses, to get the maximum tax break. Taxpayers could hold off on planned donations and some purchases to ensure that they’re all made in the same tax year, thus exceeding the larger standard deduction that they would now otherwise claim.
Eisenberg also noted that depending on a taxpayer’s situation, there could be other options. For example, he said the law still allows a taxpayer to transfer up to $100,000 directly from an IRA to a charity. By not “picking up that amount of taxable income,” a high earner could save more money by being in a lower tax bracket, Eisenberg said. Taxpayers can also put money in a donor-advised fund, which would allow them to “get the donation for that year” for tax purposes, but also allow the taxpayer to have some time to decide where the donation will go, he said.
Are Preexisting Programs Unintended ‘Victims’?
Before the IRS released its proposed regs, the view among tax experts was that the only way the agency could prevent taxpayers from using donations to claim the full federal charitable deduction and state credits from SALT cap workarounds would be to “also exclude contributions to all of these private school tuition programs” and other state tax credit donation programs, Rigney said. And that’s exactly what the IRS did with the proposed regs.
“We did kind of predict that [the preexisting state programs] would be sort of the victims of the guidance,” Rigney noted.
“I think we’re going to see a drop in charitable donations across the board for everything for a number of reasons,” Eisenberg said. “The public will get a sense of . . . these restrictions” during this year’s tax season, and “that’s when people may start really changing their thinking and behavior,” he added.
However, even without the allure of a combined state and federal tax write-off, some state programs may still attract donor support. “If somebody wants to give a donation to a specific charity” or state program, “the fact that they were getting a break” was an incentive, Eisenberg acknowledged, though he added that “if someone really wants to donate to a charity . . . the tax element should be secondary.”
London noted that some programs rely significantly on donations from businesses. The IRS released separate regulations in late December 2018, providing safe harbors for businesses to deduct as business expenses donations made in return for state tax credits.
Now What?
There is no final word on the matter yet. A hearing on the proposed regs was held in November 2018, and stakeholders are awaiting the next move.
Meanwhile, legislation to repeal the SALT cap has been introduced in the Democrat-controlled House, and President Trump has said he is open to revisiting the cap. However, Senate Finance Committee Chair Chuck Grassley, R-Iowa, has indicated that his committee won’t consider it.
A multistate lawsuit filed against the cap by New York, New Jersey, Connecticut, and Maryland argues that Congress lacks the authority to curtail the SALT deduction. And attorneys general from several states — including California, New Jersey, and Connecticut — argued in a letter to the IRS that the proposed rules are unlawful and will be challenged if implemented.
According to the letter, the IRS was prejudicial in denying individual taxpayers the ability to claim state credits and a full charitable deduction for donations to state programs and funds but allowing businesses to take credits and a business expense deduction for their giving, among other arguments.
The enactment of the TCJA “left the tax code with a lot of holes in it . . . and left it to the IRS to draft regulations, which is going to open up a lot of room for court cases” on the SALT deduction cap and other provisions, according to High. Federal courts “will adjudicate congressional intent when there’s a disagreement between the IRS and taxpayers,” she added.
Wright said there is a question whether the IRS had “good authority” to change its position regarding the charitable deduction and quid pro quos. The regulations are “not statutory at all — what’s in the statute is the cap” on the SALT deduction, she said. Although the state workarounds “are obviously trying to circumvent the intent of the statute . . . the statute doesn’t say anything about reducing the [charitable] deduction for [receiving] a state tax credit,” according to Wright.
Supporters of the regulations — and, grudgingly, even some opponents — have noted that the IRS’s position is a principled one. Taking a credit for a donation clearly provides a financial benefit to a donor, and thus can easily be argued to reduce the charitable value of the donation.
From a legal standpoint, however, the question is whether the TCJA actually contains statutory authority for the agency to suddenly change its position or disregard the reasoning upheld in prior court rulings.
“Congress, in enacting the cap on the SALT deduction, didn’t intend to restrict the federal tax deductibility of contributions” to state programs that reward taxpayers with state tax credits, Ventry argued. He noted that these programs — particularly private school tuition funds — are popular with Republicans.
“When they were considering the SALT deduction, in no way, shape, or form did they think this would affect the deductibility” of those donations, Ventry said, arguing that the TCJA’s SALT cap language doesn’t appear to authorize the IRS to protect that cap from workarounds by altering rules for the charitable deduction.
Ventry added that toward the end of 2018 some congressional lawmakers had been considering the possibility of grandfathering in pre-SALT state programs providing tax credits for donations to protect their beneficiaries, such as school tuition funds. He said that although that would have led to a legal fight, it also suggests that lawmakers could challenge the regs if they hear enough outcry from various interests in their states.