The IRS eased its new limits on state programs that let taxpayers trade donations for tax credits, issuing a clarification that allows some business owners to bypass the new $10,000 cap on the state and local tax deduction.
In August 2018, the government sharply limited that option for individuals when it issued new rules that cracked down on attempts by New York, New Jersey, and Connecticut to help their residents bypass the $10,000 cap. Those states had passed laws that used tax credits to turn nondeductible tax payments into deductible charitable contributions.
The August rule from the IRS had shut down that tactic by requiring taxpayers to subtract the value of the state and local tax credits from the amount they deduct as a charitable contribution. It reduced most of the federal tax benefit from pre-existing programs in states such as Arizona, South Carolina, and Alabama that enable taxpayers to claim tax credits for donations to private-school scholarship programs and other groups.
School-choice groups in Arizona, South Carolina, and Alabama complained about the August rules, arguing that their pre-existing tax breaks should not be pinched as part of the limits on the newer programs.
Clarification to the rule shows those programs could still be attractive to business owners seeking lower taxes, providing a potential path for some tax-credit programs to survive or expand. To qualify, instead of claiming deductions for charitable contributions that would have to be reduced by the size of the tax credit, businesses could claim the contributions as ordinary, deductible business expenses.
The change matters little to corporations, which do not face the $10,000 cap on state and local tax deductions. However, owners of partnerships and other businesses whose owners pay their business income taxes through their individual returns are subject to the $10,000 cap. By using the state tax-credit programs and the clarification, they could essentially turn nondeductible state taxes into deductible business expenses.
Treasury Secretary Steven Mnuchin stated, “The IRS clarification makes clear that the longstanding rule allowing businesses to deduct payments to charities as business expenses remains unchanged under the Tax Cuts and Jobs Act. The recent proposed rule concerning the cap on state and local tax deductions has no impact on federal tax benefits for business-related donations to school choice programs.”
For the deduction, a business would have to claim that its payments are directly related to the business and they are ordinary and necessary business expenses.
According to David Gamage, an Indiana University law professor, the limit would prevent most business owners from taking advantage of these programs. His guess is that a non-trivial number of taxpayers will be able to manufacture such reasons that are at least borderline plausible, and the IRS will have trouble policing. He stated, “But for states that want to redesign their programs, it should not be too difficult to design programs that large numbers of business-entity taxpayers should be able to qualify for.”
Before making any changes or assuming you can get a break, be sure to contact us for the latest guidance.