Charitable Contribution Deduction Receives Haircut Under Proposed IRS Regulation

At the end of 2017, Congress enacted sweeping tax reform through the Tax Cuts and Jobs Act. As part of that tax reform, an individual's ability to deduct their state and local income, real estate, and other taxes on their federal income tax return was capped at $10,000.

The federal limitation received a swift response from the states, ranging from constitutional challenges to the creation of various state tax credit programs designed to trade income tax dollars for charitable contributions. Some states enacted legislation that would allow individuals to make contributions to qualified charitable organizations and, in turn, receive a percentage of that contribution in the form of a state tax credit.

Such programs had flourished even prior to the tax reform deduction cap, with roughly 30 states offering some form of tax credit in exchange for contribution program. The IRS had issued rulings favorable to many of these arrangements; however, the enactment of a cap on deductions for state and local taxes has brought this issue into greater focus. There had been some hope that the IRS would potentially thread a needle in any response, wherein historical programs would be sustained.

On Thursday, August 23, 2018 the IRS issued proposed regulations that would have a broad impact on reducing the amount of the deduction for charitable contributions when the individual receives a state tax credit, without regard to the timing of the origination of the credit program. For Pennsylvania residents that currently participate in the Pennsylvania EITC and OSTC programs, this would be a significant impact. Under these proposed regulations, a taxpayer's charitable contribution deduction will be reduced by the amount of the state tax credit received in consideration for contributions made to charitable organizations if the credit exceeds 15 percent of the value of the contribution. For example, if a taxpayer makes a $1,000 charitable contribution and expects to receive a 90 percent state tax credit, the charitable contribution deduction will be $100.

The proposed regulations suggest a limited opportunity for taxpayers to act quickly to preserve the full deduction for charitable deductions giving rise to a state tax credit for 2018. The proposed regulations will be effective for contributions made after August 27, 2018, which means that it is possible that charitable contributions made by close of business on August 27, 2018 will not be subject to the provisions of the proposed regulations.

However, there is risk to using this strategy to preserve a charitable contribution. It is possible that an IRS examiner reviewing a 2018 tax return may seek to limit a charitable deduction, giving rise to a credit based upon the underlying statutory interpretation referenced in the proposed regulations.

For those taxpayers participating in the long-standing Pennsylvania EITC and OSTC programs, making a contribution prior to receiving their notification letter from the state might not generate the expected credit. Under the terms of the program, the charitable contribution must be made within 60 days of receiving written notification from the Department that the business firm has been approved for tax credits.

As of the writing of this alert, we have not heard that the state has sent out the notification letters. Although taxpayers entering their second year of a two year commitment should be approved for their tax credit, they do run the risk that a contribution made on August 27, 2018 may not be made within the applicable 60 day window. Given the circumstances, it is possible that the Department may issue clarification; however, it is uncertain as to when or if that will happen and the nature of the clarification issued.

Over the next few months, the IRS will be seeking comment on these regulations, which will eventually lead to a final version. The current version of the proposed regulations could be changed or modified based on the comments received during this period. Until that time comes, taxpayers should rely on the proposed regulation as guidance.

Unfortunately, due to the lack of guidance and the timing of the proposed regulation, the limited opportunity to preserve the deduction carries risk and taxpayers need to assess what level of risk they are comfortable taking. In light of these considerations, we encourage you to contact us for a more thorough discussion.