Upcoming IRS rules could chill these red-state tax credit programs

  • New guidance from the IRS and Treasury is on its way. It will address workarounds for the $10,000 cap on state and local tax deductions.
  • More than 30 states offer a state tax credit to residents who contribute to tuition scholarship programs and other state-related endeavors.
  • Some existing state programs offer taxpayers a dollar-for-dollar tax credit for their donation.

The Treasury Department and the IRS are preparing regulations on the viability of tax workarounds adopted by several high-tax states. Some lawyers are questioning whether the agencies might set their sights on other states' tax credit programs, too.

The Tax Cuts and Jobs Act, which went into effect this year, capped the state and local tax (SALT) deduction at $10,000 that filers can claim on their federal tax returns.

New York, New Jersey and Connecticut recently passed laws to create a workaround: They will permit municipalities to establish charitable funds to pay for local services and offer property tax credits to incentivize homeowners to make contributions.

Those who donate to the funds can claim a charitable tax deduction on their federal returns, exceeding the $10,000 cap on SALT deductions.

The IRS and Treasury announced they would be issuing rules to address these plans. It's unclear whether the regulation will affect already existing programs in Alabama, South Carolina and other states.

"Everyone expects them to be fairly broad in how they go about this and how to protect these well-intentioned state charitable credit programs that have been around long before this issue came into play," said Howard Wagner, a partner in the national tax office for Crowe LLP.

"It's when you get up and above a 70 percent tax credit — that's when taxpayers start to view these as not being charitable programs at all but as ways to pad their own bank accounts." -Carl Davis, research director, Institute on Taxation and Economic Policy

"These kinds of programs aren't new," said Daniel Rosen, a partner in the North America tax practice group at Baker & McKenzie.

"There are over 30 states that enable some kind of state tax credit in exchange for contributions to a state-sponsored fund or a private charitable fund," he said. "I don't see a way the IRS can credibly thread the needle, attack New Jersey and leave in place Alabama."

Countering that, Lesley Searcy, executive director for the Alabama Opportunity Scholarship Fund said, "Our program has been in place since 2013 — well before the new tax law."

"We hope that any new IRS rules around the charitable deduction will not hurt tax-credit scholarship programs, and we certainly don't think there would be any intent to do so," she said.

The Yellowhammer State's scholarship fund allows individuals to donate up to 50 percent of their Alabama income-tax liability or $50,000. Donors collect a dollar-for-dollar tax credit on their state returns.

Here's what you should know about state tax-credit programs that are currently available to the charitably inclined.

State tax credits

Osman Orsal | Reuters

A research paper authored by a group of tax law academics pointed to more than 100 existing state charitable tax-credit plans in 33 states.

Those plans vary from conservation easements to private school tuition scholarship programs.

For instance, individuals and businesses who pay South Carolina taxes can make a donation to Exceptional SC, a scholarship fund for children with exceptional needs, and claim a dollar-for-dollar tax credit against their state income-tax liability.

Indiana offers a school scholarship tax credit to individuals or businesses who donate to scholarship-granting organizations. Those who give to an eligible organization may take advantage of a 50 percent credit against their state tax liability.

What's your intent?

Charity Philanthropy
Peter Dazeley | Photographer's Choice | Getty Images

A main point of contention among tax experts is whether these programs are similar to the new plans sprouting in New York and New Jersey.

"None of these [existing] programs were designed as ways to reduce federal tax liability," said Jared Walczak, senior policy analyst at the Tax Foundation. "They are intended to promote giving, and the tax deductions weren't capped when they were created."

A key distinction is whether the contribution is made to provide a charitable benefit or paid in lieu of a tax.

"Any payment made in satisfaction of a liability is considered a tax payment," Walczak said.

Rosen of Baker & McKenzie, however, said that it's difficult to draw a legal distinction between the new SALT workarounds and plans that already exist.

He said that the tax code considers two points when it comes to charitable contributions: Is the organization entitled to receive charitable contributions? Did the donor receive something of value in exchange for the donation?

"If you have an old car in your driveway and you hear an ad for Kars for Kids, then you just want to get rid of the car," Rosen said. "You don't need to have a charitable intent to make the contribution."

Proceed with caution

Daniel Grill | Getty Images

How the IRS will ultimately proceed remains to be seen, yet experts agree that the agency may take a closer look at programs with generous tax credits.

"It's when you get up and above a 70 percent tax credit — that's when taxpayers start to view these as not being charitable programs at all but as ways to pad their own bank accounts," said Carl Davis, research director at the Institute on Taxation and Economic Policy.

For now, donors looking to slash their tax load and grab a hefty credit in their state should keep an eye on Uncle Sam.

"That pending IRS notice will hopefully clear this up for us, but in the meantime, I'd tell people to be careful with these types of gifts," said Tim Steffen, director of advanced planning at Robert W. Baird & Co. in Milwaukee.

"I would guess the IRS focus will be on the SALT workaround programs, but in fairness they probably need to think more broadly in applying the rules," he said.

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