The Internal Revenue Service this week issued final rules targeting laws in Connecticut and other high-tax states offsetting the impact of the federal cap on state and local tax deductions.

The final regulations block states from allowing charitable contribution deductions when taxpayers receive or expect to receive a corresponding state or local tax credit.

The 2017 federal tax reform measures capped the amount of state and local taxes that can be deducted on federal tax returns in a calendar year to $10,000.

Connecticut Public Act No. 18-49, enacted last year, allows municipalities to allow taxpayers to make voluntary payments to approved charitable organizations, or "community supporting organizations," in lieu of paying local property taxes, in exchange for a corresponding tax credit.

Those payments could then be deducted from federal income taxes as charitable contributions, which are not capped.

IRS Rules

Under the final IRS regulations, taxpayers can receive a federal deduction only for a charitable contribution amount that is greater than the amount of the tax credits they received.

For example, if a taxpayer donated $1,000 to a state fund and received a 70% credit against his or her state taxes, the taxpayer could claim a federal charitable tax deduction of only $300.

The IRS also issued a notice designed to protect taxpayers who itemize deductions on their federal tax returns, have less than $10,000 in state and local taxes, and donate to state tax credit programs.

Connecticut is one of four northeastern states that filed suit claiming the SALT deduction cap infringed on their constitutional right to tax.

The notice applies to donations to state charitable funds and private nonprofits and allows taxpayers who make charitable contributions to take a SALT deduction up to the amount of the state tax credit.

That deduction would still be subject to the SALT deduction cap.

Connecticut is one of four northeastern states, along with Maryland, New York, and New Jersey, that filed suit claiming the SALT deduction cap infringed on their constitutional right to tax.

That suit will be heard next month.

Pass-Through Entity Tax

The IRS rules do not affect Connecticut's 6.99% pass-through entity tax, enacted last year to mitigates the loss of SALT deductions for small businesses that pay their taxes through the personal income tax—partnerships, S corporations, and LLCs treated as partnerships.

Like business taxes paid by non-pass-through entities, PET is paid at the business level rather than the personal level and, as a result, is fully deductible from federal income taxes as a business expense.

That state tax is then offset by a personal income tax credit that effectively negates the impact of the federal cap on deductions.

The IRS has yet to challenge the Connecticut pass-through workaround.

However, the state legislature this year reduced the tax credit to 87.5%, a budget move that will cost small businesses $53 million annually.

CBIA president and CEO Joe Brennan described that decision as a "breach of trust."

"Small businesses accepted last year's workaround based on trust and this move really erodes that trust," he said.