On Aug. 7, 2020, Treasury and the IRS released final regulations (T.D. 9907) regarding the treatment of certain payments made to section 170(c) organizations in exchange for consideration, including state or local tax credits. These regulations generally adopt proposed regulations released in December 2019.
The 2017 tax law (P.L. 115-97) added section 164(b)(6), which limits the individual income tax deduction for state and local taxes to $10,000 ($5,000 married filing separately). In response to these limitations, certain states and localities instituted tax credit programs under which taxpayers may receive credits against their state or local tax obligations in exchange for contributions to entities described in section 170(c).
On June 13, 2019, Treasury and the IRS published final regulations (T.D. 9864) providing that the receipt or expectation of a state or local tax credit in exchange for a charitable contribution constitutes a quid pro quo, which reduces the taxpayer’s charitable contribution deduction. In Rev. Proc. 2019-12, the IRS provided a safe harbor under section 162 for payments or transfers for business purposes made to organizations described in section 170(c). In Notice 2019-12, the IRS provided a safe harbor under section 164 for certain individuals that made payments to organizations described in section 170(c) in return for state or local tax credits.
The newly released final regulations amend existing regulations under sections 162, 164, and 170 to reflect current law and policy and adopt safe harbors established in Rev. Proc. 2019-12 and Notice 2019-12 that clarify the tax treatment of payments made to charitable organizations in exchange for state or local tax credits.
Trade or business expenses and section 162
The regulations continue to clarify that payments made to entities described in section 170(c) that bear a direct relationship to the taxpayer’s business and are made with the expectation of a commensurate financial return constitute an allowable trade or business deduction rather than a charitable contribution.
In addition the regulations include a safe harbor for C corporations that make a cash (or cash equivalent) payment to an entity described in section 170(c) and receive (or expect to receive) a state or local tax credit in exchange. The corporation may treat such payment as an ordinary and necessary business expense to the extent of the credit received or expected to be received.
The final regulations also provide a similar safe harbor for specified passthrough entities. To qualify for the safe harbor, the entity must satisfy four requirements:
(1) The entity is a business entity other than a C corporation and is regarded for federal income tax purposes;
(2) The entity operates a trade or business within the meaning of section 162;
(3) The entity is subject to an entity-level state or local tax incurred in carrying on its trade or business; and
(4) The entity receives or expects to receive a state or local tax credit that the entity applies or expects to apply to offset an entity-level state or local tax.
However, the regulations specifically provide that the safe harbor does not apply if the credit reduces a state or local income tax.
For example, the safe harbor permits a section 162 deduction to a partnership’s payment of $1,000 to an entity described in section 170(c) in exchange for a $1,000 state tax credit that it uses to reduce its entity-level state excise tax obligation.
These amendments apply to payments made on or after Dec. 17, 2019; however, taxpayers may choose to apply the rules to payments made on or after Jan. 1, 2018.
Individual expenses and section 164
The regulations also provide a safe harbor for individuals who itemize deductions and make cash (or cash equivalent) payments to or for the use of an entity described in section 170(c) in consideration for state or local tax credits. The safe harbor permits individuals to treat the portion of a payment disallowed under section 170, as a result of the consideration received in return in the form of a state or local tax credit, to be treated as a payment of state or local tax. To the extent that the amount exceeds the individual’s state income tax liability in the year of payment, the excess may be carried forward. However, individuals remain subject to the $10,000 limit on itemized state and local income tax deductions under section 164.
These amendments apply to payments made on or after June 11, 2019; however, taxpayers may choose to apply the rules to payments made after Aug. 27, 2018.
Finally, the regulations update the quid pro quo definition under section 170 to clarify that a taxpayer is deemed to receive consideration for a payment made to an entity described in section 170(c) if at the time of the payment, the taxpayer receives or expects to receive goods or services from either the section 170(c) entity or any other party in return for its payment. Goods or services for this purpose are defined as cash, property, services, benefits, and privileges, and include state and local tax credits.
These definitions apply to amounts paid on or after Dec. 17, 2019.