The IRS this week issued proposed regulations targeting laws passed earlier this year in Connecticut and other high-tax states offsetting the impact of the federal cap on state and local tax deductions.

Announced Aug. 23, the proposed rules govern the availability of charitable contribution deductions when taxpayers receive or expect to receive a corresponding state or local tax credit.

Connecticut Public Act No. 18-49 permits 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.

Last year's 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.

How Proposed Rules Work

Under the IRS' latest proposal, residents taking advantage of the new state law must reduce their charitable deduction by the amount of the tax credit they receive or expect to receive.

The IRS provided this example:

If a state grants a 70% state tax credit and the taxpayer pays $1,000 to an eligible entity, the taxpayer receives a $700 state tax credit. The taxpayer must reduce the $1,000 contribution by the $700 state tax credit, leaving an allowable contribution deduction of $300 on the taxpayer's federal income tax return.

The proposed regulations also apply to payments made by trusts or decedents' estates in determining the amount of their contribution deduction.

Exceptions

The proposed regulations provide exceptions for dollar-for-dollar state tax deductions and for tax credits of no more than 15% of the payment amount or of the fair market value of the property transferred.

In other words, a taxpayer who makes a $1,000 contribution to an eligible entity is not required to reduce the $1,000 deduction on their federal income tax return if the state or local tax credit received or expected to be received is no more than $150.

In response to the IRS announcement, Governor Dannel Malloy said the state will assess its options.

New York, Connecticut, Maryland and New Jersey have already filed a federal lawsuit challenging the constitutionality of the SALT deduction cap.

Pass-Through Entity Tax

The latest move by the IRS does not affect the state's new 6.99% pass-through entity tax mitigating the loss of SALT deductions for certain 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 new personal income tax credit that effectively negates the impact of the federal cap on deductions.

"So far, the IRS has not challenged Connecticut's plan to ease the burden on small businesses resulting from the cap on state and local tax deductions," said CBIA vice president for government affairs Eric Gjede.

"That's not to say the feds won't challenge PET in the future, but for now it appears to be safe."


For more information, contact CBIA's Eric Gjede (860.480.1784) | @egjede