IRS to Issue Guidance on SALT Workarounds, Raises Issue of Substance over Form

The IRS has now fired its first salvo in the SALT workaround controversy.  Notice 2018-54 announces the IRS’s intention to propose regulations to deal with some types of SALT workarounds.

In one sense this notice gives us little information about exactly what can and cannot pass muster when taxpayers make charitable contributions that reduce their state income taxes in an effort to shift from a nondeductible expense (state and local taxes in excess of $10,000) to fully deductible items (charitable contributions). But it does indicate that the IRS does not plan to sit by quietly and not issue guidance in this area.

The tone of the notice makes it clear we should expect the IRS to determine certain arrangements will not achieve their desired goals. As Section 2 of the Notice states:

Despite these state efforts to circumvent the new statutory limitation on state and local tax deductions, taxpayers should be mindful that federal law controls the proper characterization of payments for federal income tax purposes.

Section 3 outlines the guidance the IRS plans to release:

The Treasury Department and the IRS intend to propose regulations addressing the federal income tax treatment of transfers to funds controlled by state and local governments (or other state-specified transferees) that the transferor can treat in whole or in part as satisfying state and local tax obligations. The proposed regulations will make clear that the requirements of the Internal Revenue Code, informed by substance-over-form principles, govern the federal income tax treatment of such transfers. The proposed regulations will assist taxpayers in understanding the relationship between the federal charitable contribution deduction and the new statutory limitation on the deduction for state and local tax payments.

The notice does not give any information on the likely timing of the release of such proposed regulations, let alone whether they will be issued in a form taxpayers may rely upon.

Most likely the ultimate decision on what does or does not work will be finally determined in litigation that will arise as taxpayers who give to programs that are deemed not charitable contributions under such regulations (very conceivably with help from the state governments in question) challenge the regulations. 

But since most clients would prefer not to find themselves parts of cases discussed in this forum, it seems likely that many clients will want to await this guidance before committing to any such transfer from income taxes to charitable contribution program—and most will likely shy away from a program that is clearly on the wrong side of the eventual regulations.

A related concern may impact taxpayers in states other than those have adopted SALT workarounds.  About two-thirds of states have at least one (if not more) tax credits that give 100% or a close to 100% credit against state taxes for various charitable contributions.  Advisers in those states will want to pay close attention to how these regulations define “other state-specified transferees” in this context. It is at least conceivable that this guidance might rope in some pre-existing programs depending on how that definition is structured.

For now all advisers can do is advise clients about the risks, especially of donating to the charitable funds established following the passage of the Tax Cuts and Jobs Act that were clearly enacted to work around the $10,000 state and local tax limitation.