Not a Recipe – Just a Response to Workarounds
The Tax Cuts and Jobs Act (TCJA) capped the state and local tax (SALT) deduction at $10,000. That means taxpayers are limited to that amount when filing their federal returns. This category includes state income tax, real estate tax and personal property taxes … clearly adding a particularly heavy burden on high-income residents of states with high taxes in this classification.
In response, several high-tax states have recently passed laws to create a workaround to circumvent the $10,000 cap. To bypass the maximum limit on the deduction, states and municipalities set up charitable funds to which taxpayers may contribute. In exchange for the donation taxpayers receive a state tax credit. This gambit is designed to allow taxpayers who itemize deductions to claim both a charitable deduction and a state tax credit.
To understand the significance of this move, let’s start with a brief lesson of “What are tax credits?” The best way to describe tax credits is in contrast to what most taxpayers understand … tax deductions. Tax deductions reduce the amount of your income subject to tax. Tax credits directly reduce the tax itself.
For example, assume you or your business spends $10,000 that results in a tax deduction. That will reduce your taxable income by $10,000. In a 25% tax bracket, you would save $2,500 in taxes.
Compare that with a $10,000 tax credit. That amount is subtracted from the amount of tax owed as opposed to an offset to income … as is the case with a tax deduction. Result: Your tax bill is reduced by the full $10,000 tax credit!
Now assume the above described workarounds results in a state tax credit delivering tax relief. For example, imagine that you made a $10,000 contribution and received a tax credit for $6,500. That would reduce your state tax by $6,500 … AND an itemized deduction on your federal return of $10,000.
Predictably, the IRS is not pleased with this turn of events. Its answer is a proposed regulation that would reduce the amount claimed as a deduction on the federal return by the value of the state tax credit. In the example above, the $10,000 would not be permitted as an itemized deduction; it would be reduced by the $6,500 credit. The charitable contribution would be limited to only $3,500.
Keep in mind that the proposed regulation is just that … proposed … with a window of several weeks to receive replies and clarify final rules. While the IRS has reacted to the few states that have initiated workarounds, there is reason to believe that existing state tax credit programs will come under closer scrutiny by the agency.
Note: On September 5, 2018, the IRS said that business taxpayers who make business-related payments to charities or government entities for which the taxpayers receive state or local tax credits can generally deduct the payments as business expenses. The IRS clarified that this general deductibility rule is unaffected by the recent notice of proposed rulemaking concerning the availability of a charitable contribution deduction for contributions pursuant to such programs.
Virginia is not one of the “workaround” states. That is not to say there are not tax credit programs in place that bear watching whether the IRS may extend its regulation to affect existing programs. Here in the Commonwealth, two come to mind … the Neighborhood Assistance Tax Credit (NAP) and the Education Improvement Scholarships Tax Credit.
Neighborhood Assistance Tax Credit (NAP):
The purpose of the Neighborhood Assistance Program (NAP) is to encourage businesses, trusts and individuals to make donations to approved non-profit - 501(c) (3) - organizations for the benefit of low-income persons. In return for their contributions, tax credits equal to 65 percent of the donation may be applied against their state income tax liability.
Education Improvement Scholarships Tax Credit (EITSC)
With approval from the Virginia Department of Education, donations to approved scholarship foundations earn a tax credit equal to 65 percent of the donation.
Under TCJA the net tax results of a $10,000 donation to either of the above (remember, tax credits hold the most appeal to high-income taxpayers) will be a $6,500 tax credit which reduces your state tax by that amount.
So, here in Virginia, donors to either of the two programs referenced above may be severely impacted. There are over 30 states that enable some kind of tax credit in exchange for contributions to a state-sponsored fund. It is difficult to believe that the IRS will attack the workaround states and not apply the rules more broadly.
That said the best current stance is to remain alert … and stay tuned.