The IRS has released proposed regulations that would shut down some suggested workarounds for the new $10,000 limit on the deductibility of state and local taxes (SALT). The new guidance would close the door on a strategy offered by some states to circumvent the deduction limit by attempting to turn the taxes paid into charitable contributions not subject to the same cap.
Historically, if you itemized deductions on your federal income tax return, you could generally claim a deduction for taxes paid to state and local governments, including income and property taxes (or sales tax in lieu of income tax). For 2018 to 2025, the deduction for state and local taxes is limited to $10,000 ($5,000 for married taxpayers filing separate returns).
Some high-tax states have proposed potential workarounds to the new federal limit on the deduction for state and local taxes, including:
- Providing a credit to taxpayers for charitable contributions to a state-created charity in lieu of payment of state income tax (or possibly for the amount of state tax in excess of the $10,000/$5,000 limit); the taxpayer would then claim a federal charitable tax deduction for the payment.
- Imposing a tax on employers instead of on employees; it’s suggested that the employer could deduct the tax as a business expense on its federal tax return and correspondingly reduce the amount paid to an employee, who effectively receives the same amount on an after-tax basis.
The proposed regulations address only the concept of trying to reposition payment of state taxes as charitable contributions.
The proposed IRS regulations would restrict the charitable deduction workaround by:
- Reducing the federal charitable deduction for individuals to the extent that a state provides a state or local tax credit in return for a payment or transfer of property to charity. However, the federal deduction for charitable contributions would not be reduced if the state or local tax credit does not exceed 15%.
- Reducing the federal charitable deduction for individuals if a tax deduction is provided at the state or local level in return for a payment or transfer of property to charity, in cases where that deduction is greater than the amount of the payment (or the fair market value of donated property).
The proposed regulations have an effective date for amounts paid and property transferred after August 27, 2018.
An individual makes a payment of $1,000 to a charity. In exchange for the payment, the individual is entitled to a state tax credit of 70% of the payment. The federal charitable deduction is reduced by $700 ($1,000 x 70%) to $300.
An individual contributes a painting worth $100,000 to a charity. In exchange for the contribution, the individual is entitled to a state tax credit of 15% of the fair market value of the property. The federal charitable deduction is not reduced because the credit does not exceed 15%.
An individual makes a payment of $1,000 to a charity. In exchange for the payment, the individual is entitled to a state tax deduction equal to the amount of the payment. The federal charitable deduction is not reduced because the deduction does not exceed the amount of the payment.
Whether or not these limits based on state or local tax credits or deductions apply, the amount of your charitable deduction may be limited to certain percentages of your adjusted gross income, depending on the type of charity and the property contributed.