On December 13, 2019 the IRS released proposed regulations REG-107431-19 on how to treat contributions made to a charity in return for state and local tax (SALT) credits. The proposed regulations incorporate two earlier pieces of IRS guidance, Rev. Proc. 2019-12 and Notice 2019-12. This release is the latest in the effort to curb state attempts to evade the $10,000 cap on state and local tax deductions.
Proposed regulations REG-107431-19 include guidance on:
The treatment of business entity payments to charitable entities;
The treatment of payments by individuals in exchange for state and local tax credits;
The application of the “quid pro quo” principle to benefits received or expected to be received by the donor from a party other than the donee.
The treatment of business entity payments to charitable entities
The first issue tackled by the proposed regulation concerns how business entity payments are treated. The proposed regulation clarifies the current state of the law regarding the taxpayer’s payment or transfer to an entity.
The rule states if the taxpayer’s payment bears a direct relationship to its trade or business, and the payment is made with a reasonable expectation of commensurate financial return, the payment or transfer to the Sec. 170(c) entity may constitute an allowable deduction as a Sec. 162 trade or business expense rather than a Sec. 170 charitable contribution. The proposed regulation also contains an example that shows that the rule would apply regardless of whether the taxpayer expects to receive a state or local tax credit in return.
The proposed regulation also encompasses the safe harbor contained in Rev. Proc. 2019-12. The revenue procedure states that, to the extent that a C corporation or specified pass-through entity receives or expects to receive a state or local tax credit in return for a payment to an organization described in Section 170(c), it is reasonable to conclude that there is a direct benefit and a reasonable expectation of commensurate financial return to the C corporation’s business in the form of a reduction in the state or local taxes that the C corporation would otherwise be required to pay. Therefore, the revenue procedure provides a safe harbor that allows a C corporation engaged in a trade or business to treat the portion of the payment that is equal to the amount of the credit received or expected to be received as meeting the requirements of an ordinary and necessary business expense under Section 162.
Further, a specified pass-through entity other than a C corporation, for the purpose of the proposed regulation is eligible for the same treatment if certain criteria are met: (1) the business entity is regarded as separate from its owner for federal tax purposes; (2) the pass-through entity operates a trade or business within the meaning of Section 162; (3) the pass-through entity is subject to a state or local tax incurred in carrying on its trade or business that is imposed directly on the entity; and (4) in return for a payment to an entity described in Section 170(c), the pass-through entity receives or expects to receive a state or local credit that the entity applies or expects to apply to offset a state or local tax other than a state or local income tax. Under Rev. Proc. 2019-12, specified pass-through entities that meet these qualifications may treat the payments as meeting the requirements of an ordinary and necessary business expense under Section 162.
The treatment of payments by individuals in exchange for state and local tax credits
Secondly, the proposed regulations incorporate the safe harbor issued in Notice 2019-12 that was released last June. Under this safe harbor, an individual taxpayer who itemizes deductions and makes a payment to a Sec. 170(c) entity in exchange for a state or local tax credit may treat as a payment of state or local tax for Sec. 164 purposes the portion of that payment for which a Sec. 170 charitable contribution deduction would be disallowed under Regs. Sec. 1.170A-1(h)(3). This treatment is allowed in the tax year in which the payment is made, but only to the extent that the resulting credit is applied under state or local law to offset the individual’s state or local tax liability for that or the preceding tax year.
The application of the “quid pro quo” principle
Lastly, the proposed regulations would amend Regs. Sec. 1.170A-1(h) to make it clear that the quid pro quo principle applies regardless of whether the party providing the quid pro quo is the donee or a third party. In either case, the donor’s payment is not a charitable contribution to the extent the donor expects to receive a substantial benefit in return.
For further reference on the developments concerning SALT Cap Workarounds, please consult your Schneider Downs tax advisor or see the previous “Our Thoughts On” articles written by tax professionals at Schneider Downs:
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