IRS provides safe harbors related to the SALT deduction

The Internal Revenue Service is offering business taxpayers some safe harbors related to the state and local tax deduction that was limited under the Tax Cuts and Jobs Act, but only when they make charitable contributions.

Timothy Fadek/Bloomberg

The IRS released Revenue Procedure 2019-12, which provides safe harbors under section 162 of the tax code for certain payments made by a C corporation or a specified pass-through entity to, or for the use of, an organization if the C corporation or specified pass-through entity receives, or expects to receive, a state or local tax credit in return for such a payment.

The tax overhaul that Republicans pushed through last December limited the amount of state and local tax deductions that taxpayers could claim to $10,000, provoking howls of protest from lawmakers in so-called “Blue states” where taxes tend to be higher. Several Democratic-leaning states, such as New York, New Jersey and California, have tried to find workarounds such as setting up state-run funds where taxpayers could pay their taxes and claim them as charitable deductions, but the Treasury Department has indicated it would not allow that strategy to pass muster, at least for individual taxpayers.

However, it has been more open to some charitable deduction workarounds for business taxpayers, with Treasury Secretary Steven Mnuchin even reassuring businesses that contribute to school choice programs that they would be able to continue to do so (see IRS will allow contributions to state and local tax credit programs as deductible business expenses). “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,” Mnuchin said in September. “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.”

In September the Treasury and the IRS issued guidance in the form of frequently asked questions to spell out its view of the matter. “The FAQ states that the proposed regulations do not affect the availability of an ordinary and necessary business expense deduction under section 162," the IRS said in the revenue procedure it issued Friday. "Specifically, the FAQ states that a business taxpayer making a payment to a charitable or government entity described in section 170(c) is generally permitted to deduct the payment as an ordinary and necessary business expense under section 162 if the payment is made with a business purpose. The FAQ also notes that the rules permitting an ordinary and necessary business expense deduction under section 162 apply to a taxpayer engaged in carrying on a trade or business regardless of the form of the business.”

But since the release of the FAQ, the Treasury Department and the IRS continued to receive questions regarding the application of the proposed regulations and sections 162 and 164 to taxpayers engaged in trades or businesses. “These questions include whether payments by these taxpayers to organizations described in section 170 in return for state income, property, and other business tax credits would bear a direct relationship to the taxpayer’s trade or business, such that these payments would be considered ordinary and necessary business expenses of carrying on such trade or business under section 162(a) to the extent of the credit received or expected,” the IRS said in the guidance Friday. “To the extent a C corporation receives or expects to receive a state or local tax credit in return for a payment to an organization described in section 170(c), it is reasonable to conclude that there is a direct benefit to the C corporation’s business in the form of a reduction in the state or local taxes the C corporation would otherwise have to pay and, therefore, to the extent of the amount of the credit received or expected to be received, there is a reasonable expectation of financial return to the C corporation commensurate with the amount of the transfer."

The guidance also applies to pass-through entities such as S corporations. "Similarly, in the case of a business entity other than a C corporation that is regarded as separate from its owner for all federal tax purposes under section 301.7701-3 of the Procedure and Administration Regulations (pass-through entity) and that is operating a trade or business within the meaning of section 162, to the extent the credit received in return for such a payment can reduce the pass-through entity’s tax liability, it is reasonable to conclude that there is a direct benefit to the pass-through entity in the form of a reduction in the state or local taxes the entity would otherwise have to pay," said the revenue procedure. "However, under the principles of sections 702 and 1366, the deductibility of the payment must be determined at the level of the individual owners of the entity if the credit received or expected to be received will reduce a state or local income tax subject to the limitations in section 164(b)(6). Accordingly, section 3 of this revenue procedure provides a safe harbor for C corporations, and section 4 of this revenue procedure provides a separate safe harbor for specified pass-through entities described in section 4.02 this revenue procedure.”

The IRS has not been releasing much guidance this week because of the partial government shutdown, which applies to the Treasury Department. But an IRS spokesman said in an email that the agency is allowed to make an exception for guidance related to the Tax Cuts and Jobs Act. “As a side note, there is no Internal Revenue Bulletin number at this point due to the appropriations lapse,” he added. “The guidance itself is coming out because work related to TCJA is exempt and still allowed during the lapse.”