IRS Shuts Down State Tax Workaround

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.

Background
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.

Proposed regulations
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 percent.
  • 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 percent of the payment. The federal charitable deduction is reduced by $700 ($1,000 x 70 percent) 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 percent of the fair market value of the property. The federal charitable deduction is not reduced because the credit does not exceed 15 percent.

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.

Please consult your tax preparer for expert advice about how this might apply to you.


Important Disclosures

*Past performance is not an indicator of future results. This material is not financial advice or an offer to sell any product. The statements contained herein are solely based upon the opinions of Elevage Partners, LLC (“Elevage”). Elevage is a registered investment adviser. More information about the firm can be found in its Form ADV Part 2, which may be requested by calling (877) 922-8243 or visiting http://www.adviserinfo.sec.gov. The information contained herein is derived from sources we believe to be reliable, but which we have not independently verified. Elevage assumes no responsibility for errors, inaccuracies or omissions in this information. Elevage reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. The information provided in this report should not be considered a recommendation to purchase or sell any particular security. There is no assurance that any securities discussed herein will remain in an account’s portfolio at the time you receive. It should not be assumed that any of the securities transactions, holdings or sectors discussed were, or will prove to be profitable, or that the investment recommendations or decisions Elevage makes in the future will be profitable or will equal the investment performance of the securities discussed herein.
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