The Tax Cuts and Jobs Act of 2017 amended Code Sec. 164(b)(6) to limit individual annual State and Local Tax (SALT) deductions to a maximum of $10,000, with no carryover for taxes paid in excess of that amount. As a result of this change, many taxpayers will not get a full federal income tax deduction for their payments of state and local taxes.
In response to this, many state legislatures—particularly those of high-tax states—implemented workarounds to mitigate the impact of the new SALT deduction limit on their residents. One method was the establishment of charitable funds to which taxpayers can contribute and receive a tax credit in exchange. (About 100 programs in 30 states take advantage of such workarounds.)
On August 27, 2018, the IRS issued proposed regulations that would effectively eliminate state workarounds by attempting to turn the taxes paid into charitable contributions not subject to the same cap. In other words, people who get a state tax credit in exchange for a tax-deductible donation must reduce the charitable deduction they take on their federal return by the amount of the credit.
Example: If a taxpayer donates $1,000 to an entity eligible to receive tax-deductible contributions and gets a $700 tax credit, the taxpayer can deduct only $300 on a federal return. The IRS did make an exception for credits less than 15 percent. So, if the same taxpayer got a credit of $150 or less for a $1,000 deduction, the taxpayer could still deduct $1,000 as a charitable contribution.
Currently, the SALT deduction limit doesn’t apply to property taxes paid in connection with a trade or business or in connection with the production of income. However, the newly proposed regulations led to widespread confusion regarding business expenses and deductions, prompting the IRS to issue a clarification on September 5, 2018. The statement explained that taxpayers who make business-related payments to charities or government entities for which they receive SALT credits can continue to claim business expense deductions for these payments. In other words, those business deductions are unaffected by the proposed regulations. They also clarified that the business expense deduction is available to any business taxpayer as long as the payment qualifies as an ordinary and necessary business expense.
The IRS could change these rules before making them final. We will be keeping an eye on it. If you have any questions about how these proposed changes might impact you, don’t hesitate to reach out to us.