For many years, states provided incentives for taxpayers to contribute to certain charitable organizations or state sponsored activities by giving a generous credit against state income tax obligations. Such tax credits have been as high as 50 percent in Maryland and 65 percent in Virginia for the amount contributed. The incentive helped encourage direct community investment and charitable engagement from taxpayers and reduce the burden on state legislatures to budget or monitor grants to organizations providing beneficial services to the community. It essentially let the taxpayers vote with their dollars. As an additional benefit, the contributor was permitted to deduct the entire contribution as a charitable deduction on their federal income tax return.
Charitable Contribution Deductions
But with issuance of a new regulation, which went into effect on August 27, charitable contribution deductions will no longer be allowed because taxpayers may have already “paid” the maximum deductible amount for state and local taxes (SALT). Taxpayers are seen as receiving a quid pro quo benefit of their contribution instead of substituting the charitable contribution for the SALT payment. The maximum SALT deduction for tax years 2018-2025 is $10,000 ($5,000 for married filing separate).
The new regulation will likely impact community foundations and charities that depend upon such donations to fund their programs. While donors do make charitable contributions from a sense of goodwill and generosity, the size or beneficiary of an individual’s contribution can be greatly influenced by tax credits or other quid pro quo benefits.
Taxpayers will continue to see financial benefits of taking advantage of state credits offered despite the reduced federal charitable contribution deduction by the required reductions. The estimated federal tax cost for the reduced deduction referenced in the example below is only $240 at the highest tax bracket of 37 percent. The taxpayer contributes $1000, receives $650 state tax credit, benefit of a federal deduction of $350, they are effectively only out of pocket $221, which is not a bad return on investment.
Prior to the proposed regulation the IRS allowed full deductions for contributions to state charity programs where the contributing taxpayer received tax benefits for the contribution on the presumption that dollars not deducted as a charitable contribution would be deductible as a state or local tax payment. Had the taxpayer had not made the charitable contribution, they would have been required to pay a tax liability in cash.
The regulation requires the contribution deduction be reduced for the amount of tax credit received. For example, a contribution of $1000 that is eligible for a state credit of 65 percent, only $350 will be deductible on the federal return. Virginia will not require modification to the deduction. However, other states may require modification to deductions if the taxpayer received benefit of a tax credit. The regulation provides leeway for tax credits 15 percent or less of the amount contributed. There will be no limitation on the charitable deduction at the federal level, and the taxpayer will be able to take advantage of the credit offered.
While the new regulation seems to specifically target certain high tax states instead of searching for alternatives to the SALT deduction limitations, this new regulation makes sense as it is based on longstanding federal tax law principles. Under the Internal Revenue Code Section 170(a)(1), deductions are permitted for contributions to qualified charities. In 1986, the Supreme Court held that charitable deductions are not permitted when the contributor expects a substantial benefit in return (Quid Pro Quo). State tax credits issued in exchange for contribution can be considered Quid Pro Quo where the taxpayer is receiving financial benefit through reduced tax obligation as a result of the contribution.
Anyone donating to charities or those managing charitable accounts needs to understand how this updated regulation can be an opportunity and/or a detriment. Contact your tax advisor or reach out to PBMares for advice on how to use the new regulation to your advantage.
PBMares’ tax partner Carolyn Irwin and tax manager Amy Cudia also contributed to this article.