These proposed regulations provide guidance on the deductibility of charitable contributions when a taxpayer receives or expects to receive a corresponding state or local tax credit. These proposed regulations are intended to clarify the relationship between the federal charitable contribution deduction and the recently-enacted statutory limitation on deductions for state and local taxes paid (the “SALT cap”) and to make the federal tax system more neutral with respect to taxpayers’ decisions regarding donations. Compelling policy considerations reinforce the interpretation and application of section 170 in this context. Disregarding the value of all state tax benefits received or expected to be received in return for charitable contributions would precipitate revenue losses that would undermine and be inconsistent with the limitation on the deduction for state and local taxes adopted by Congress in section 164(b)(6).

Pursuant to section 6(a)(3)(B) of Executive Order 12866, the following qualitative analysis provides further details regarding the anticipated impact of the proposed regulations. After identifying a baseline in Part II, this analysis provides illustrative scenarios in Part III. Part III.A describes the tax effects of the contributions prior to enactment of the SALT cap in the Act. Part III.B provides examples comparing the enactment of the SALT cap but absent the proposed rule (the baseline) to the proposed rule. Finally, Part IV provides a qualitative assessment of the potential costs and benefits of the proposed rule compared to the baseline.

Prior to this proposed rule, there was no authoritative regulatory guidance on the treatment of state or local tax credits arising from charitable contributions to entities listed in section 170(c), and there was no guidance aside from Notice 2018–54 addressing the interaction between section 170 and the newly enacted SALT cap. As a result, there was a degree of taxpayer uncertainty as to whether state and local tax credits are a return benefit that reduces a taxpayer’s charitable contribution deduction. For informational and analytical purposes, however, this analysis assumes as a baseline that state and local tax credits are generally not treated as a return benefit or consideration and therefore do not reduce the taxpayer’s charitable contribution deduction under section 170(a).

For the following illustrative scenarios, assume the following facts: Charitable organizations A and B are entities listed in section 170(c) and provide similar public goods. Contributions to charity A are eligible for a dollar-for-dollar state tax credit. Contributions to charity B are ineligible for this credit but are deductible from state taxable income. A taxpayer itemizes deductions, and these itemized deductions in aggregate are at least $1,000 more than the standard deduction. The taxpayer has the choice to contribute $1,000 to charity A, and this $1,000 contribution generates a state tax credit of $1,000,^[2] that is, the tax credit is dollar-for-dollar but does not otherwise figure into the calculation of the taxpayer’s state tax liability. The taxpayer has more than $1,000 of state tax liability, so that the taxpayer’s state tax liability is reduced by the entire $1,000 of the state tax credit. Finally, if the taxpayer makes the $1,000 contribution that generates a state tax credit of $1,000, the taxpayer reduces by $1,000 the withholdings or other payments of state taxes during the taxable year in question. The state taxes paid by the taxpayer are therefore reduced by the full amount of the state tax credit in the same taxable year as the contribution is made.^[3] Further assume the taxpayer is in the 24 percent federal tax bracket, itemizes federal tax deductions, and has a state tax rate of 5 percent. If the taxpayer is subject to the AMT, assume an AMT marginal tax rate of 26 percent.

The Act and proposed regulations alter the incentives taxpayers face about whether and how much to give to organizations that receive charitable contributions as well as to which organizations. This is illustrated in the following scenarios, which are also summarized in Table 1 (below).

The tax effects of contributions prior to enactment of the Act are illustrated in the columns labeled “Prior Law” in Table 1.

Prior to enactment of the Act, if the taxpayer made a $1,000 contribution to charity A that generated a state tax credit of $1,000, the deduction for charitable contributions under section 170(a) increased by $1,000, and the deduction for state and local taxes paid under section 164 decreased by $1,000. The taxpayer’s itemized deductions, taxable income, and federal tax liability were unchanged from what they would have been in the absence of the contribution.^[4] The taxpayer’s state tax liability decreased by $1,000 because of the state tax credit. The combined federal and state tax benefits of the $1,000 contribution were therefore $1,000, and the cost to the taxpayer and to the federal government of making the contribution was $0. This is shown in column A under Prior Law for Example 1 in Table 1 and replicated in the same column for Example 2.

If the taxpayer were subject to the AMT under section 55, however, there was a net benefit to the taxpayer from contributions to charity A, which provided state tax credits. State and local taxes paid are not deductible expenses in determining taxable income under the AMT, but charitable contributions are deductible expenses in determining taxable income under the AMT. If the taxpayer contributed $1,000, taxable income under the AMT was reduced by $1,000 due to the charitable contribution deduction under section 170, but there was no corresponding reduction in the deduction for state and local taxes. Under an AMT marginal tax rate of 26 percent, the federal tax benefit of this $1,000 contribution would be $260. Because of the dollar-for-dollar state tax credit, the taxpayer received a combined federal and state tax benefit of $1,260 for a $1,000 contribution, a net benefit of $260. This is shown in column A under Prior Law for Example 3 in Table 1.

In combination, state and federal tax laws generally provide a greater incentive to contribute to organizations eligible for state tax credits (charity A) than to other organizations (charity B). The effect of a contribution to charity A are described above.

Prior to enactment of the Act, for a taxpayer not subject to the AMT, a $1,000 contribution to charity B yielded a smaller combined federal and state tax benefit than to charity A. The state tax benefit was $50 ($1,000 times the 5 percent state tax rate). The taxpayer’s itemized deductions at the federal level increased by $950 (the $1,000 charitable contribution deduction less the $50 reduction in state taxes paid). The federal tax benefit of this increase was $228 ($950 times the 24 percent federal tax rate), resulting in a combined federal and state tax benefit of $278. The net cost to the taxpayer of the $1,000 contribution was $722. This is shown in column B under Prior Law for Example 1 in Table 1 and replicated in the same column for Example 2.

For a taxpayer subject to the AMT, a $1,000 contribution to charity B yielded a combined federal and state benefit of $310—the $1,000 contribution multiplied by the taxpayer’s marginal tax rate under the AMT of 26 percent, or $260, plus the value of the deduction from state tax, or $50 ($1,000 times the 5 percent state tax rate). The net cost to the taxpayer of the $1,000 contribution was $690. This is shown in column B under Prior Law for Example 3 in Table 1.

Contributing to either charity A or charity B reduced the taxpayer’s combined federal and state tax liability, but the existence of the state tax credit for contributions to charity A made contributions to that organization more attractive. This is seen by comparing the Total Tax Benefit in column A under Prior Law to the corresponding value in column B for each of the three examples. For taxpayers not subject to the AMT, contributions to charity A yielded a combined federal and state tax benefit of $1,000, compared to a combined federal and state tax benefit of $278 for a contribution to charity B. The AMT increased the disparity for contributions to charity A versus charity B, resulting in a combined federal and state tax benefit of $1,260 for a contribution to charity A versus $310 for a contribution to charity B.

The enactment of the SALT cap in the Act has, in limited circumstances, altered the federal tax effects of charitable contributions as described in the following examples. These are illustrated in the columns labeled “Baseline” and “Proposed Rule” in Table 1.

If a taxpayer that has a state tax liability of more than $1,000 above the SALT cap and is not subject to the AMT makes a $1,000 contribution to charity A, the deduction for charitable contributions under section 170(a) increases by $1,000, but the deduction for state and local taxes paid under section 164 is unchanged. Consequently, itemized deductions increase by $1,000, and taxable income decreases by $1,000. If the taxpayer is in the 24 percent bracket, federal liability will decrease by $240, and state tax liability will decrease by the $1,000 state tax credit. The combined federal and state tax benefits of the $1,000 contribution are therefore $1,240, and the taxpayer receives a $240 net benefit while the federal government has a loss of $240. This is shown in column A under Baseline for Example 1 in Table 1.

If the same taxpayer makes the $1,000 contribution to charity A under the proposed rule, the entire $1,000 deduction is not deductible under section 170(a), and the deduction for state and local taxes paid under section 164 is unchanged due to the SALT cap. The taxpayer’s itemized deductions, taxable income, and federal tax liability are unchanged from what they would be in the absence of the contribution. The taxpayer’s state tax liability decreases by $1,000 because of the state tax credit. The combined federal and state tax benefits of the $1,000 contribution are therefore $1,000, or $240 less than under the baseline. This is shown by comparing the Total Tax Benefit in column A under Proposed Rule with the corresponding value in column A under Baseline for Example 1 in Table 1. However, the benefit of the contribution for this taxpayer is the same as the taxpayer faced prior to enactment of the Act. This is shown by comparing the Total Tax Benefit under column A under Proposed Rule with the corresponding value in column A under Prior Law for Example 1 in Table 1.

Under the baseline and the proposed rule, for a taxpayer with state and local taxes paid over the SALT cap, the value of a contribution to charity B, that is a contribution that results in a one-for-one state income tax deduction and not a state tax credit, is slightly higher than it was pre-Act. This increase is because the state deduction does not reduce the federal deduction for state and local taxes for a taxpayer above the SALT cap. As shown in the Total Tax Benefit row under the B columns for Example 1, under the baseline and the proposed rule, the value of a $1,000 contribution to charity B is $290—the charitable contribution deduction from federal tax ($1,000 times the 24 percent federal tax rate, or $240), plus the value of the deduction from state tax ($1,000 times the 5 percent state tax rate, or $50)—compared to $278 for contributions under prior law (described above). By comparison, as shown in the Total Tax Benefit row under the A columns for Example 1, a contribution to charity A, eligible for a state tax credit, yields a $1,240 tax benefit under the baseline and a $1,000 benefit under the proposed rule.

If a taxpayer that has state and local taxes paid below the SALT cap and is not subject to the AMT makes the $1,000 contribution to charity A, the deduction for charitable contributions under section 170(a) increases by $1,000, and the deduction for state and local taxes paid under section 164 decreases by $1,000. The taxpayer’s itemized deductions, taxable income, and federal tax liability are unchanged from what they would be in the absence of the contribution. The taxpayer’s state tax liability decreases by $1,000 because of the state tax credit. The combined federal and state tax benefits of the $1,000 contribution are therefore $1,000, and the cost to the taxpayer and to the federal government of making the contribution was $0. This situation is identical to prior law or what taxpayers faced prior to enactment of the Act. This is shown is column A under Baseline and Prior Law for Example 2 in Table 1.

If the same taxpayer makes the $1,000 contribution to charity A under the proposed rule, the entire $1,000 contribution is not deductible under section 170(a), but the deduction for state and local taxes paid under section 164 still decreases by $1,000 because of the $1,000 state tax credit. If the taxpayer is in the 24 percent bracket, the federal tax liability will increase by $240. The taxpayer’s state tax liability decreases by the $1,000 state tax credit. The combined federal and state tax benefits of the $1,000 contribution are therefore $760, or $240 less than the baseline. This is shown by comparing the Total Tax Benefit in column A under Proposed Rule with the corresponding value in column A under Baseline for Example 2. In this case, the proposed rule has the effect of increasing the taxpayer’s federal taxable income compared to the baseline if the taxpayer makes a contribution to charity A.

Under prior law, and both the baseline scenario and the proposed rule, the tax benefit of charitable contributions to charity B, which are not eligible for a state tax credit but are deductible from both federal and state taxable income, is unchanged from prior law for taxpayers below the SALT cap. Thus, in this example, the benefit of making a contribution to charity B remains $278, as described above for contributions under prior law. This is shown in the Total Tax Benefit row under the B columns for Example 2. By comparison, as shown in the Total Tax Benefit row under the A columns for Example 2, a $1,000 contribution to charity A, eligible for a state tax credit, yields a $1,000 tax benefit under the baseline and a $760 benefit under the proposed rule.

^[5]

If a taxpayer subject to the AMT makes a $1,000 contribution to charity A, the contribution reduces the taxpayer’s taxable income under the AMT by $1,000. Under an AMT marginal tax rate of 26 percent, the federal tax benefit of this $1,000 contribution is $260. Because of the dollar-for-dollar state tax credit, the taxpayer would receive a combined federal and state tax benefit of $1,260 for a $1,000 contribution, or a $260 net benefit. This result is identical to the result under prior law (prior to enactment of the Act). This is shown in the A columns under Baseline and Prior Law for Example 3 in Table 1.

If the same taxpayer makes the $1,000 contribution to charity A under the proposed rule, the entire $1,000 is not deductible under section 170(a). Therefore, the taxpayer’s taxable income and federal tax liability under the AMT would be unchanged from what they would be in the absence of the contribution. The taxpayer’s state tax liability decreases by $1,000 because of the state tax credit. The combined federal and state tax benefits of the $1,000 contribution are therefore $1,000, or $260 less than under the baseline and under the law prior to enactment of the Act. This is shown by comparing the A columns of Example 3 in Table 1. However, under the proposed rule, taxpayers subject to the AMT are in the same position as taxpayers with state and local taxes paid above the SALT cap who are not subject to the AMT. This is shown by comparing the Total Tax Benefit amount under column A for the Proposed Rule for Example 3 to that for Example 1.

Under the baseline and the proposed rule, the treatment of charitable contributions that are deductible from both federal and state taxable income is unchanged from prior law for taxpayers subject to the AMT. This is shown in the B columns for Example 3 in Table 1. In this example, the benefit of making a contribution to charity B remains $310, as described above for contributions under prior law. By comparison, a contribution to a charity A, eligible for a state tax credit, yields a $1,260 tax benefit under the baseline and a $1,000 benefit under the proposed rule. This is shown in column A under Baseline and Proposed Rule for Example 3 in Table 1.

These proposed regulations likely reduce economically inefficient choices motivated by the potential tax benefits described above if these proposed regulations were not promulgated. Under the prior law and baseline scenarios, state and local governments have an incentive to fund governmental activities through independent entities that are eligible to receive deductible contributions and to establish tax credits. This incentive is particularly strong under a SALT cap scenario where state and local governments may do so solely to enable some taxpayers to circumvent the SALT cap. These proposed regulations substantially diminish this incentive to engage in socially wasteful tax-avoidance behavior. As a result, it is expected that fewer such credit programs would be established in the future under the proposed regulations than under the baseline.

To the extent this result occurs, the Treasury Department and IRS estimate that the proposed regulations would reduce overall complexity and paperwork burden for states and for taxpayers who would otherwise engage in charitable contributions solely for the purpose of reducing their state and local tax liability. In addition to reducing paperwork burden, the Treasury Department and IRS anticipate that the proposed regulations will also spare some taxpayers compliance costs associated with complex tax planning designed to avoid the SALT cap.

In addition, these proposed regulations are expected to make the federal tax system more neutral to taxpayers’ decisions regarding donations. Under the baseline scenarios, the combined federal and state tax benefits favor contributions to organizations which give rise to a state tax credit for taxpayers, particularly for taxpayers above the SALT cap. Under the proposed regulations, this economic distortion is expected to be reduced. The Treasury Department and the IRS request comments from the public on the potential extent of this expected reduction in economic distortion.

Finally, these proposed regulations provide more certainty to taxpayers by clarifying the rules governing the amount that they can claim as a charitable contribution deduction when they receive a state tax credit or a dollar-for-dollar state tax deduction in exchange for the contribution.

The proposed regulations may result in some increase in compliance costs for taxpayers who make contributions that generate state tax credits. Under the baseline, for purposes of the charitable contribution deduction under section 170(a), taxpayers did not need to address state tax credits received for purposes of claiming a charitable contribution; however, they would know the amount of credits received as part of the filing process for state returns. In contrast, under the proposed regulations, taxpayers making a contribution to an organization listed in section 170(c) will need to determine the amount of any state tax credits they will receive or expect to receive in order to reduce their charitable contribution deduction under section 170(a). This additional step will generate some additional compliance costs.

The compliance burden for recipient organizations that directly issue tax credits may increase under the proposed regulations. In order to take a charitable contribution deduction of $250 or more, a taxpayer must have a contemporaneous written acknowledgment (CWA) from the donee entity, usually provided in the form of a letter. The CWA includes the amount received by the entity or a description of property received. The CWA must also disclose whether the donee provided any goods or services in consideration for the contribution and a description and good faith estimate of the value of those goods or services provided. State and local tax credits are not generally provided by the donee entity, but there may be situations in which the entity would be providing the credit and would need to include it in the CWA provided to the donor. The Treasury Department and the IRS request comments on whether additional guidance is needed on substantiation and reporting requirements for donors and donees making or receiving payments or transfers of property in return for state and local tax credits and the extent to which entities do provide tax credits under certain circumstances.

The Treasury Department and the IRS request comments on other potential compliance savings, compliance costs, costs related to increased tax planning and other avoidance behavior, or any effects on charitable contribution decisions that may occur as a result of these proposed regulations. In particular, the Treasury Department and the IRS request comments as to how the proposed regulations might alter incentives regarding contributions to state and local tax credit programs.

Based on an analysis of confidential taxpayer return data and forecasts using that data, the Treasury Department and the IRS note that these proposed regulations will leave charitable giving incentives entirely unchanged for the vast majority of taxpayers. After passage of the Act, which significantly increased the standard deduction, it is estimated that ninety percent of taxpayers will not claim itemized deductions of any kind. Those taxpayers are entirely unaffected by these proposed regulations. It is estimated that approximately five percent of taxpayers will itemize and will have state and local income tax deductions above the SALT cap; these taxpayers will receive the same federal tax benefits under the proposed regulations as they received prior to the Act. See Example 1 above. It is estimated that approximately five percent of taxpayers will itemize but will not have state and local income tax deductions above the SALT cap. The federal tax benefits available to this fraction of taxpayers could be affected by the proposed regulations only if they contribute to programs that entitle them to state tax credits of greater than 15 percent. See Example 2 above. The Treasury Department and the IRS believe that most taxpayers in this third category have never used any state tax credit programs affected by the proposed regulations, and that the proposed regulations will have at most a highly limited, marginal effect on taxpayer decisions to donate to tax credit programs that pre-date TCJA, including educational scholarship programs.^[6] The Treasury Department and the IRS request comments on this important consideration and any potential unintended consequences of the proposed regulations not addressed here.

The Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply because the proposed regulations primarily affect individuals and do not impose costs, including a collection of information, on small entities. Therefore, a regulatory flexibility analysis is not required. Pursuant to section 7805(f), this notice of proposed rulemaking will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small businesses.

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(h) * * *

(3) Payments resulting in state or local tax benefits. (i) State or local tax credits. Except as provided in paragraph (h)(3)(v) of this section, if a taxpayer makes a payment or transfers property to or for the use of an entity listed in section 170(c), the amount of the taxpayer’s charitable contribution deduction under section 170(a) is reduced by the amount of any state or local tax credit that the taxpayer receives or expects to receive in consideration for the taxpayer’s payment or transfer.

(ii) State or local tax deductions. (A) In general. If a taxpayer makes a payment or transfers property to or for the use of an entity listed in section 170(c), and the taxpayer receives or expects to receive a state or local tax deduction that does not exceed the amount of the taxpayer’s payment or the fair market value of the property transferred by the taxpayer to such entity, the taxpayer is not required to reduce its charitable contribution deduction under section 170(a) on account of such state or local tax deduction.

(B) Excess state or local tax deductions. If the taxpayer receives or expects to receive a state or local tax deduction that exceeds the amount of the taxpayer’s payment or the fair market value of the property transferred, the taxpayer’s charitable contribution deduction under section 170 is reduced.

(iii) In consideration for. For purposes of paragraph (h)(3)(i) of this section, the term in consideration for shall have the meaning set forth in § 1.170A–13(f)(6), except that the state or local tax credit need not be provided by the donee organization.

(iv) Amount of reduction. For purposes of paragraph (h)(3)(i) of this section, the amount of any state or local tax credit is the maximum credit allowable that corresponds to the amount of the taxpayer’s payment or transfer to the entity listed in section 170(c).

(v) State or local tax. For purposes of paragraph (h)(3) of this section, the term state or local tax means a tax imposed by a State, a possession of the United States, or by a political subdivision of any of the foregoing, or by the District of Columbia.

(vi) Exception. Paragraph (h)(3)(i) of this section shall not apply to any payment or transfer of property if the amount of the state or local tax credit received or expected to be received by the taxpayer does not exceed 15 percent of the taxpayer’s payment, or 15 percent of the fair market value of the property transferred by the taxpayer.

(vii) Examples. The following examples illustrate the provisions of this paragraph (h)(3). The examples in paragraph (h)(6) of this section are not illustrative for purposes of this paragraph (h)(3).

Example 1. A, an individual, makes a payment of $1,000 to X, an entity listed in section 170(c). In exchange for the payment, A receives or expects to receive a state tax credit of 70% of the amount of A’s payment to X. Under paragraph (h)(3)(i) of this section, A’s charitable contribution deduction is reduced by $700 (70% x $1,000). This reduction occurs regardless of whether A is able to claim the state tax credit in that year. Thus, A’s charitable contribution deduction for the $1,000 payment to X may not exceed $300.

Example 2. B, an individual, transfers a painting to Y, an entity listed in section 170(c). At the time of the transfer, the painting has a fair market value of $100,000. In exchange for the painting, B receives or expects to receive a state tax credit equal to 10% of the fair market value of the painting. Under paragraph (h)(3)(vi) of this section, B is not required to apply the general rule of paragraph (h)(3)(i) of this section because the amount of the tax credit received or expected to be received by B does not exceed 15% of the fair market value of the property transferred to Y. Accordingly, the amount of B’s charitable contribution deduction for the transfer of the painting is not reduced under paragraph (h)(3)(i) of this section.

Example 3. C, an individual, makes a payment of $1,000 to Z, an entity listed in section 170(c). In exchange for the payment, under state M law, C is entitled to receive a state tax deduction equal to the amount paid by C to Z. Under paragraph (h)(3)(ii)(A) of this section, C is not required to reduce its charitable contribution deduction under section 170(a) on account of the state tax deduction.

(viii) Effective/applicability date. This paragraph (h)(3) applies to amounts paid or property transferred by a taxpayer after August 27, 2018.

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Par. 3. Section 1.170A–13(f)(7) is amended by removing the cross-reference “§ 1.170A–1(h)(4)” and adding in its place “§ 1.170A–1(h)(5)”.

Par. 4. Section 1.642(c)–3 is amended by adding paragraph (g) to read as follows:

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(g) Payments resulting in state or local tax benefits—(1) In general. If the trust or decedent’s estate makes a payment of gross income for a purpose specified in section 170(c), and the trust or decedent’s estate receives or expects to receive a state or local tax benefit in consideration for such payment, § 1.170A–1(h)(3) applies in determining the charitable contribution deduction under section 642(c).

(2) Effective/applicability date. Paragraph (g)(1) of this section applies to payments of gross income after August 27, 2018.