On June 11, 2019, the Treasury Department and the Internal Revenue Service issued final regulations (TD 9864, 6/11/2019) in response to legislation enacted by a number of states and their political subdivisions aimed at allowing their residents to avoid the $10,000 annual limitation on the deductibility of state and local tax (SALT) payments brought about under newly enacted tax code Section 164(b)(6) under the Tax Cuts and Jobs Act.
Rejection of CCA 201105010 Holding That Charitable Deduction Isn’t Reduced by Tax Credits Received in Return
The preamble to the final regulations states that the new SALT limitation, and the resulting efforts by states and taxpayers to devise alternate means for deducting the disallowed portion of their state and local taxes, has generated increased interest in the question of whether a state or local tax credit should be treated as a return benefit—a quid pro quo—when received in return for making a payment or transfer to an entity described in Section 170(c). It specifically states that the “Treasury Department and the IRS did not publish formal guidance on this question before the enactment of the limitation under section 164(b)(6).”
It is interesting that the preamble to the final regulations specifically notes that in CCA 201105010(Oct. 27, 2010) (2010 CCA), “the IRS Chief Counsel advised that, under certain circumstances, a taxpayer may take a deduction under section 170 for the full amount of a contribution made in exchange for a state tax credit, without subtracting the value of the credit received in return.” Although 2010 CCA recognized the general principal that the value of a quid pro quo benefit reduces the charitable income tax deduction otherwise available, it specifically stated that “a state or local tax benefit is treated for federal tax purposes as a reduction or potential reduction in tax liability. As such, it is reflected in a reduced deduction for the payment of state or local tax under §164, not as consideration that might constitute a quid pro quo, for purposes of §170.” (Emphasis added.) On this basis, longstanding tax credit programs offered charitable contribution deductions, without reduction for an otherwise quid pro quo benefit received in the form of a state or local tax credit. While 2010 CCA isn’t legally binding precedent, the IRS has never published formal guidance to the contrary and has apparently applied the conclusion reached in 2010 CCA to such programs.
In the preamble, the “Treasury Department and the IRS acknowledge that the proposed and final regulations depart from the conclusion of the 2010 CCA in important respects.” In support of such a departure, the preamble states that the 2010 CCA failed to persuasively explain why state and local tax credits should not count as return benefits for purposes of applying the quid pro quo principle. Furthermore, it states that the analysis in the 2010 CCA assumed that after the taxpayer applied the state or local tax credit to reduce the taxpayer’s state or local tax liability, the taxpayer would receive a smaller deduction for state and local taxes under Section 164. The preamble also states that with the enactment of Section 164(b)(6), “that assumption no longer holds true for the vast majority of taxpayers. The changes in the tax laws reduce the number of taxpayers who will itemize deductions, and for taxpayers who itemize and have state and local tax liabilities above the new limitation, the use of the tax credit would not reduce the deduction for state and local taxes.”
The preamble states that in light of the Section 164(b)(6) limitation, the Treasury Department and the IRS have specifically considered the application of the quid pro quo principle to state and local tax credit programs and “have determined that it is appropriate to treat the receipt or the expectation of receipt of state and local tax credits as return benefits.” As a result, the final regulations reject the 2010 CCA’s conclusion that the contribution deduction does not need to be reduced by the value of the state and local tax credit received or expected to be received. In reaching this conclusion, the preamble cites various legal authority for the principle that a charitable contribution deduction is not available where there the donor receives a substantial benefit in return. For example, it cites United States v. American Bar Endowment, where the Supreme Court stated that the “sine qua non of a charitable contribution is a transfer of money or property without adequate consideration,” that is, without the expectation of a quid pro quo. In that case, the Court held that a “payment of money generally cannot constitute a charitable contribution if the contributor expects a substantial benefit in return.”
The Treasury and the IRS further state in the preamble that the treatment of state and local tax benefits as a quid pro quo is consistent not only with the purpose of Section 170, but also with the Section 164(b)(6) limitation, stating:
“If the Treasury Department and the IRS were to allow taxpayers to claim a full charitable contribution deduction for contributions made in exchange for state tax credits, this treatment would result in significant federal tax revenue losses that would undermine the limitation on the deduction for state and local taxes in section 164(b)(6). Such an approach would enable taxpayers to characterize payments as fully deductible charitable contributions for federal income tax purposes, while using the same payments to satisfy their state tax liabilities. As a result, the final regulations reject the 2010 CCA’s conclusion that the contribution deduction does not need to be reduced by the value of the state and local tax credit received or expected to be received.”
Section 170(f)(8) Contemporaneous Written Acknowledgment Issues
To curb perceived abuses in situations where a taxpayer makes a payment to charity, but receives goods or services in return, i.e., so-called “quid pro quo contributions,” Congress enacted certain measures in 1993 to ensure that the income tax deduction taken in these situations is limited to the true value that actually inures to the charity. One such measure was the enactment of the “contemporaneous written acknowledgment” requirement under Section 170(f)(8). Under this provision, no deduction is allowable for any contribution of $250 or more unless the donor obtains a contemporaneous written acknowledgment from the donee charity containing the information specified under Section 170(f)(8), including indicating whether any “goods or services” were provided in consideration for a taxpayer’s contribution. Section 170(f)(8) specifically provides that “[n]o deduction shall be allowed … for any contribution of $250 or more unless the taxpayer substantiates the contribution by a contemporaneous written acknowledgment of the contribution by the donee organization.”
Thus, the failure of a donor to obtain a written contemporaneous acknowledgment for a claimed contribution of $250 or more results in the denial of the entire deduction. See, e.g., Addis v. Commissioner, where the court stated that the “deterrence value of section 170(f)(8)’s total denial of a deduction comports with the effective administration of a self-assessment and self-reporting system”; see also Bruzewicz v. United States, where in support of disallowing a claimed deduction for a charitable contribution of a facade easement, the court stated that the taxpayer’s total failure to comply with Section 170(f)(8) “is alone fatal to their claim deduction of the preservation façade easement.”
In addition to the statute itself imposing the obligation on the donor to obtain the acknowledgment, the legislative history of Section 170(f)(8) also indicates that such obligation is not placed on the charitable donee but is the responsibility of the donor claiming the deduction. See Staff of Senate Comm. on Budget, 103d Cong., 1st Sess., “Reconciliation of Submission of the Instructed Committees Pursuant to the Concurrent Resolution on the Budget.” See also HR Conf. Rep. 103-213, at 563–564 (1993) (Section 170(f)(8) “does not impose an information reporting requirement upon charities; rather it places the responsibility upon taxpayers … to request … substantiation from the charity of their contribution (and any good or service received in exchange)”). Unlike in the context of Section 6115, where a charity is subject to penalty for the failure to provide a written disclosure for a “quid pro quo” contribution over $75, there is no penalty imposed on a charity that does not provide a contemporaneous written acknowledgment under Section 170(f)(8). However, a donee organization that knowingly provides a false contemporaneous written acknowledgment to a donor may be subject to penalties for aiding and abetting an understatement of tax liability under Section 6701.
While Section 170(f)(8) does not itself provide a definition of “goods or services,” the term is broadly defined in the regulations to mean “cash, property, services, benefits, and privileges,” so that all forms of consideration provided should fall under the purview of the contemporaneous donee acknowledgment requirement, including the provision of a state or local tax credit in return for the contribution. Reg. 1.170A-13(f)(5). The IRS has taken the position that consideration provided by a third party to a donor, as opposed to consideration flowing directly from the donee charitable organization, must be included in the contemporaneous written acknowledgement required to be obtained by the donor under Section 170(f)(8).
In Seventeen Seventy Sherman Street, LLC v. Commissioner, for example, Seventeen Seventy Sherman Street, LLC granted conservation easements to Historic Denver, a charitable organization whose role was largely as the City of Denver’s designee to hold easements, and claimed a charitable income tax deduction for the donation of “Interior and Exterior Easements.” In return for the contribution of the easements, the taxpayer negotiated and received the commitment of the local planning agency, the Community Planning and Development Agency (CPDA) of the City of Denver, to recommend approval (1) by the City of Denver to change the Planned Unit Development (PUD) statute applicable to the property from PUD 373 to PUD 545, so as to expand the permitted use of the property; and (2) by the Denver Planning Board of a view plane zoning variance sought by the taxpayer in connection with the development of the property. The court noted that CPDA’s position during the negotiations was that it would not recommend approval of either the proposed PUD or the view plane variance unless the taxpayer committed to granting interior and exterior conservation easements on the property. Ultimately, with the recommendation of the CPDA, PUD 545 was approved by the City and the zoning variance was approved by the Denver Planning Board. The IRS made a number of arguments for disallowing the charitable income tax deduction in its entirety. Ultimately, the court disallowed the deduction based on Seventeen Seventy not meeting its burden of proving that the fair market value of the donated easements exceeded the value of the consideration it received in exchange for the contribution of the easements.
One alternative argument made by the IRS in Seventeen Seventy Sherman Street for the disallowance of the entire charitable income tax deduction was that Seventeen Seventy Sherman Street, LLC did not meet the contemporaneous written acknowledgment requirements of Section 170(f)(8), including failing to obtain a statement of the consideration received in return for the contribution of the easement. The taxpayer disagreed with the IRS’s position, contending “that the plain language of sec. 170(f)(8) requires a description and good-faith estimate of the value of consideration received only from the donee organization (i.e., Historic Denver) and not from a third party (i.e., the city of Denver).” (Emphasis added.) In this case, because the consideration flowed to the donor from the City of Denver and not directly from the donee organization, the taxpayer asserted that such consideration need not be included in the contemporaneous written acknowledgment under the requirements of Section 170(f)(8). The Tax Court, albeit in dictum and in a footnote, sided with the IRS, stating the following:
“We find dubious … contentions that Seventeen Seventy was not required to report the consideration it received from the city of Denver in exchange for the easements and that it therefore complied with the requirements of sec. 170(f)(8). The grant of the easements was a complex negotiation among Seventeen Seventy, the city of Denver, and Historic Denver. Historic Denver’s role, however, was largely as the city of Denver’s designee to hold the easements. Thus, we generally find persuasive respondent’s argument that Seventeen Seventy was required to disclose the consideration it received in exchange for the easements to substantiate its deduction under sec. 170(f)(8).”
Because the court held that the grant of the interior and exterior easements was part of a quid pro quo exchange and Seventeen Seventy Sherman Street, LLC failed to prove that the fair market value of the donated easements exceeded the consideration it received in the exchange, the court stated that “we do not decide whether Seventeen Seventy failed to substantiate its claimed deduction because it failed to obtain a contemporaneous written acknowledgement meeting the requirements of sec. 170(f)(8).”
Although an argument could be made under the literal language of Section 170(f)(8) that only consideration flowing directly from the donee charity to the donor should be included in the contemporaneous written acknowledgment, such an argument, as the court indicated in Seventeen Seventy Sherman Street, may not succeed. Disclosure of any third-party consideration in return for the contribution is clearly the prudent course of action given the potential consequence of the total denial of the claimed charitable income tax deduction under Section 170(f)(8), as well as the potential imposition of a penalty upon a donee organization that knowingly provides a false contemporaneous written acknowledgment to a donor. Thus, in light of the final regulations, a donor and donee charity will act at their own risk where an acknowledgment under Section 170(f)(8) for a contribution to a charity resulting in a state or local tax credit includes only the amount of the contribution and not the tax credit received in return.
Notice 2019-12: Safe Harbor to Allow Tax Deduction Under Section 164 for Payments Disallowed as Charitable Contribution Under Final Regulations
After the publication of the proposed regulations, stakeholders expressed concern, through comments and through testimony at the public hearing, that the proposed regulations would create unfair consequences for certain individuals who receive state or local tax credits in return for payments to Section 170(c) entities. Specifically, donors to such tax credit programs who itemize deductions for federal income tax purposes and have total SALT liability for the year under $10,000 would be precluded from taking charitable contribution deductions for payments to Section 170(c) entities to the extent the donors receive state or local tax credits even though the donors would have been able to deduct equivalent payments of state and local taxes offset by such credits. As a result of the proposed regulations, if these individuals chose to make a payment to a Section 170(c) entity instead of paying tax to the state or local government, they would lose a deduction otherwise available under Section 164 to which they would otherwise have been entitled had they made a tax payment directly to the taxing authority.
In response to this issue, on the same day the final regulations were issued, the IRS issued Notice 2019-12 (6/11/2019), which stated that the “Treasury Department and the IRS take seriously the concern that the proposed regulations could create unfair consequences for individuals who (i) itemize deductions for federal income tax purposes, (ii) make a payment to a section 170(c) entity in return for a state or local tax credit, and (iii) would have been able to deduct a payment of tax to the state or local government in the amount of the credit. A safe harbor is appropriate to mitigate the consequences of the proposed regulations in the situation described above.” The notice then announced that proposed regulations will be issued to amend Reg. 1.164-3 to provide a safe harbor for individuals who make a payment to or for the use of an entity described in Section 170(c) in return for a state or local tax credit.
Under the safe harbor, an individual who itemizes deductions and who makes a payment to a Section 170(c) entity in return for a state or local tax credit may treat as a payment of state or local tax for purposes of Section 164 the portion of such payment for which a charitable contribution deduction under Section 170 is or will be disallowed under final regulations. For example, assume that a taxpayer who itemizes deductions pays $6,000 in SALT payments during the year and makes a payment to charity of $12,000 for which a state tax credit of $11,000 is provided. Under Reg. 1.170A-1(h)(3)(i), $11,000 of the $12,000 payment to charity would be disallowed as a charitable contribution, so that the charitable contribution would be equal to only $1,000. Under Notice 2019-12, the $11,000 amount disallowed as a charitable contribution would be treated as a tax payment under Section 164. Because the taxpayer already has $6,000 in SALT payments, only $4,000 of the $11,000 amount treated as a tax payment would be deductible as a state tax payment because of the $10,000 annual SALT limitation on deducibility under Section 164(b)(6).
The treatment as a payment of state or local tax under Section 164 is allowed in the taxable year in which the payment is made to the extent the resulting credit is applied, consistent with applicable state or local law, to offset the individual’s state or local tax liability for such taxable year or the preceding taxable year. To the extent the resulting credit is not applied to offset the individual’s state or local tax liability for the taxable year of the payment or the preceding taxable year, any excess credit permitted to be carried forward may be treated as a payment of state or local tax under Section 164 in the taxable year or years for which the carryover credit is applied, consistent with applicable state or local law, to offset the individual’s state or local tax liability. The safe harbor does not apply to a transfer of property.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Richard L. Fox is a shareholder in the Philadelphia office of Buchanan, Ingersoll & Rooney, PC.