Proposed Regulations Issued Regarding Tax Reform’s SALT Deduction CAP on Federal Income Tax

Update: On September 20, a U.S. district court denied the legal challenge mounted by New York, New Jersey, Connecticut, and Maryland to block the SALT deduction cap.  It is uncertain at the time of this update whether the case will be appealed.

Proposed regulations were issued on August 23 regarding the individual state and local tax (SALT) deduction cap under the 2017 tax reform act,^[1] known as the Tax Cuts and Jobs Act (TCJA).  The cap introduces a limitation on the deductibility of state and local property and income taxes from federal taxable income of $10,000, starting with taxable years beginning in 2018 and before 2026.  While the limitation impacts all individual taxpayers, it places disproportionate pressure on taxpayers who will file returns in states with high income and property taxes, including New York, New Jersey, Connecticut, California, Maryland, and Oregon, and on married couples (regardless of whether they file jointly or separately).  The cap limits taxpayers’ SALT deductions to $10,000 per return, and married taxpayers who file separately can only deduct up to $5,000 each. 

States’ reaction to the cap

In opposition to the federal income deduction cap, New York, New Jersey, Connecticut, and Maryland are suing the administration to invalidate the new limit.  Many states are also attempting workarounds of the SALT deduction limitation, such as enacting an optional payroll tax (New York), enacting a new, mandatory pass-through entity tax (Connecticut), and enacting legislation that authorizes charitable contributions in lieu of local property taxes and in exchange for a property tax credit (New Jersey, New York, Connecticut).

California currently offers tax credits in exchange for donations supporting the Cal Grant program, which provides loan-free tuition aid to California college students.  S.B. 539, which is currently moving through the state Assembly, increases the value of the tax credit granted for donations to the program from 50 percent to 75 percent of the taxpayer contribution amount for taxable years beginning on or after January 1, 2018. The bill is similar to donation programs in other states that provide state tax credits for contributions to private education tuition that predate the SALT cap and have been upheld by the IRS in prior guidance (e.g. IRS Tech. Adv. Mem. 201105010 (Feb. 4, 2011)). 

 

IRS and Treasury response: Notice 2018-54 and proposed regulations

Responding to these individual state workarounds, the IRS issued Notice 2018-54 announcing the IRS’s intention to propose regulations addressing the treatment of transfers to state- or locally-controlled funds at the federal income tax level.  Notice 2018-54 reminds taxpayers that federal law controls the proper characterization of payments for federal income tax purposes, and furthermore, states that the proposed regulations will assist taxpayers to understand the relationship between the federal charitable contribution deduction and the new statutory limitation on the deduction for SALT payments.

The proposed regulations are now available for review and comment.  We’ve summarized the main points below.

The proposed regulations begin by summarizing the interplay between Section 170 and certain workarounds by the states’ regarding the SALT cap.  Section 170(c)(1) allows taxpayers to itemize a deduction for contributions or gifts for the use of a state or a possession or political subdivision of the United States, as long as the contribution or gift is made exclusively for public purposes.  As a result of tax reform, Section 164 now limits the amount of deduction a taxpayer can make to his or her federal taxable income from SALT payments. However, if a taxpayer makes a payment or transfers property to or for a charitable contribution as defined under Section 170(c), and receives a SALT credit in return, the taxpayer can potentially contribute towards their SALT amount owed while reducing their federal taxable income.  The proposed regulations state that when a taxpayer receives or expects to receive a SALT credit in return for a payment or transfer to a Section 170(c) entity, this constitutes a quid pro quo that may preclude a full deduction under Section 170(a), and would reduce the federal charitable deduction amount equal to the SALT credit received. 

The proposed regulations also address SALT deductions that are claimed to circumvent the cap under Section 164(b)(6).  On this matter, the IRS and Treasury view such risk as comparatively low. However, if the taxpayer receives or expects to receive a state or local tax deduction that is greater than the amount of the taxpayer’ payment or the fair market value of the property transferred, the taxpayer’s charitable contribution deduction must be reduced.  The IRS and Treasury have requested comments on how to determine the amount of this reduction.

There is a de minimis exception. If a state or local tax credit received in exchange for a charitable contribution does not exceed 15 percent of the taxpayer’s payment or of the fair market value of the property transferred, the taxpayer’s charitable contribution deduction is not reduced by the credit.

The proposed regulations apply after August 27, 2018, if finalized. The proposed regulations also include details on the special analysis conducted per the Office of Management and Budget’s review.

 

BDO Insights

As workarounds and further guidance related to the SALT deduction unfold, taxpayers should be aware of what their states’ approach will be and what federal guidance has to say about the treatment of deductible payments for federal tax purposes in time for 2018 returns.  It is interesting to note that versions of the workarounds in process today by several states are similar to pre-existing charitable contribution programs, such as private school tuition tax credits enacted by other state.  The impact of the proposed regulations will likely extend beyond the programs introduced recently to similar, older programs.