The IRS issued its final regulations on the tax treatment of transfers made to charitable entities in return for “consideration.” Among other things, the rules tackle a recent tax strategy for avoiding the limit on state and local tax deductions imposed by the Tax Cuts and Jobs Act (TCJA). The regs also include an important clarification about application of the quid pro quo principle.
Contributions for consideration
In response to the TCJA’s tighter cap on state and local tax (SALT) deductions (generally $10,000), some individual or business taxpayers considered strategies that incorporate state and local programs to circumvent it. Under these programs, state and local governments provide tax credits in return for donations to the charitable funds they created (for example, for education). The programs vary by state.
Typically, taxpayers would make a contribution to the state program and receive a charitable contribution deduction in the full amount for federal income tax purposes — as well as tax credits against their state and local taxes.
For example, say a taxpayer has a $30,000 property tax bill. Under the TCJA, he could deduct only $10,000 of that amount. By contributing $30,000 to a state fund, he obtains a $30,000 federal charitable contribution deduction and tax credits against some or all (depending on the state program) of his property tax liability.
Under existing proposed regulations created to eliminate the circumventing of the SALT deduction cap, the taxpayer’s charitable deduction amount is reduced by the amount of the state tax credit (because the credit is considered a nondeductible quid pro quo, also known as a “return benefit”). To be considered a charitable contribution, the payment can’t be made with the expectation of receiving such a benefit.
The final regulations allow an individual taxpayer to treat the credit as state or local tax for purposes of the state and local tax deduction if the credit is used to offset state or local tax liability. The amount is subject to the limit, though. A C corporation may treat the payment as an ordinary and reasonable business expense.
A notable clarification
The final regs also clarify the rule that limits deductions for quid pro quo contributions to the amount exceeding the fair market value of goods or services the donor receives in exchange for a contribution. Some commenters on the proposed regulations asserted that a quid pro quo doesn’t reduce the taxpayer’s charitable deduction if a third party service (for example, an area business) provides the goods, or because the charity itself hadn’t incurred the expense.
Additionally, the final regs clarify that the source of the return benefit is immaterial. When providing the disclosure statement required for quid pro contributions of more than $75, include the fair market value of the goods and services the donor received. This applies whether you incurred the expense for these benefits or if a third party donated them to you.
After the TCJA took effect, some taxpayers may have channeled their donations away from traditional nonprofits to state funds that could offer a charitable deduction and a way to avoid state and local tax deduction limits. At a time when some nonprofits have seen steep declines in donations, let’s hope they reconsider.