IRS Warns on State Charitable Deduction Schemes to Allow Property Taxes Deduction

The Tax Cuts and Jobs Act of 2017 limits the Code §164 deduction of individuals for state and local taxes to $10,000 per year ($5,000 for married individuals filing a separate return). Thus, many taxpayers in states with high state taxes have lost a federal income tax subsidy of their state and local taxes.

Several states have adopted or are proposing arrangements to convert tax payments to deductible charitable deductions. These work by allowing taxpayers to make their tax payments to state-established or sanctioned charitable organizationS and then receive a credit against their state taxes for these payments. Voila - a state tax payment (subject to the $10,000 limit) is converted to a deductible charitable payment (not subject to the $10,000 limit).

The IRS has issued Notice 2018-54 warning taxpayers of proposed regulations that will be coming out that will address these payments. The Notice does not explicitly provide that the above charitable deduction arrangement will be ineffective - no such level of detail is provided. It does, however, specifically describe those arrangements and also references the “substance-over-form” doctrine, so it is highly likely that the regulations will disallow the charitable deduction under these arrangements.

Note that in the past, the IRS has provided that such charitable contribution/state tax credit arrangements allowed for a charitable deduction. Such was the conclusion in Office of Chief Counsel Internal Revenue Service Memorandum 201105010. However, that memorandum implies that the taxpayers did not receive a disqualifying quid pro quo in receiving the state tax credit for the charitable deduction, at least in part because a federal income tax deduction was allowable both for charitable deductions and state and local tax payments. Now that the state and local tax deduction is limited, I would expect the IRS to hold that by receiving the state tax credit the taxpayers are receiving a valuable quid pro quo - a federal tax deduction that would not otherwise be available for a direct tax payment. Thus, the charitable deduction would not be available. Alternatively, or also, the IRS may rely on the substance-over-form doctrine it mentions in its Notice to challenge the charitable deduction.

Notice 2018-54, Guidance on Certain Payments Made in Exchange for State and Local Tax Credits

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