Are these a valid end-run around the new $10,000 limitation?
The Tax Cuts and Jobs Act (the Act)1 is the most far-reaching change to the Internal Revenue Code in over 30 years. Among other significant changes is the elimination or limitation until 2026 of most itemized deductions that had been allowed for individuals for federal income tax purposes. Although the state and local tax (SALT) deductions weren’t eliminated, the Act places an annual $10,000 limit on them under new IRC Section 164(b)(6). This new limitation has prompted certain states (and, in some cases, their political subdivisions) that impose high taxes to consider legislative proposals that would allow their residents to avoid the new $10,000 annual deduction limitation or curb its impact.
Proposals being considered by at least three states, California, New Jersey and New York, provide for contributions to certain charitable organizations, which support state (and local) functions, to be allowed as a credit against certain state (and local) taxes. This, in effect, would provide the same benefit of allowing a deduction without the $10,000 annual deduction limitation on SALT payments, although charitable contribution limits set forth in the IRC would apply. States are still in the process of considering sustainable approaches in this context. Legislation has already been introduced in California, SB 227, the “Protect California Taxpayers Act,” which would allow taxpayers to receive a dollar-for-dollar state tax credit for amounts they contribute to the “California Excellence Fund,” a fund created “to accept monetary contributions for exclusively public purposes as specified under Section 170 of the Internal Revenue Code, relating to charitable contributions and gifts” for which “[a]ll amounts in the fund shall be used for those public purposes upon appropriation by the Legislature.” Other proposals would limit the state tax credit to 85 percent of the contribution.
Governor Andrew Cuomo of New York “would transfer the personal income tax to a payroll tax on business. Because the new law allows a business to deduct that state tax expense from its federal taxes, the governor and his team reckon that the state’s residents as a whole would continue to get the federal deduction regardless of the $10,000 limit.”2 The effect would be to make the employer pay the tax, which may be fully deductible for federal income tax purposes, and pay employees that much less, but only this lesser payment would be subject to federal income tax in the hands of the employee. From the employee’s perspective, it’s the same as though he’d received the gross amount, paid the state income tax on that amount and received a full deduction for the state tax payment. In fact, employees might benefit in that they could still take the standard deduction, which was significantly increased by the Act, and yet realize the benefit of itemizing as to the state income tax payment.
The issue that arises in this context, of course, is whether a purported charitable contribution to or for the benefit of a state is deductible under IRC Section 170(a) in light of the donor receiving a quid pro quo benefit in the form of state tax credits in return for the contribution. Although Section 170(c) makes it clear that a contribution to a state (or a political subdivision thereof) qualifies for a charitable tax deduction (but only if the contribution “is made for exclusively public purposes”), it’s black letter law that when a donor makes a purported charitable contribution and receives equal fair market value (FMV) in return, the transfer will be considered to lack donative intent and, therefore, won’t be deductible under Section 170(a).
Charitable Contribution Deductions
Section 170(a) allows as a deduction any “charitable contribution” as defined in Section 170(c). Section 170(c), in turn, provides that the term “charitable contribution” means a contribution or gift to or for the use of certain specified entities under Section 170(c)(1) through (5). The deduction available for a contribution to a state is derived from Section 170(c)(1), which permits a deduction for a contribution made to a “State, a possession of the United States, or any political subdivision of any of the foregoing, or the United States or the District of Columbia, but only if the contribution or gift is made for exclusively public purposes.”
The term “exclusively public purposes” should also be contrasted from the purposes requirement of Section 170(c)(2), which permits a deduction under Section 170(a) for a contribution made to a domestic entity organized and operated “exclusively for religious, charitable, scientific, literary, or educational purposes,” which generally includes an organization described under Section 501(c)(3). Thus, a contribution to a state for exclusively public purposes will be deductible even if it isn’t used for one of the purposes enumerated under Section 170(c)(2). Indeed, the courts have determined that a contribution made for “public purposes” may be used for different and broader purposes than a contribution that’s made for religious, charitable, scientific, literary or educational purposes.3
Meaning of Charitable Contribution
Not every payment to a qualified organization under Section 170(c), which includes a state or local government, constitutes a charitable contribution for income tax purposes.4 To be considered a “charitable contribution,” a transfer of cash or property must constitute a “contribution or gift” within the meaning of Section 170(c). The requirement that a payment to charity be a “contribution or gift” is “intended to differentiate between unrequited payments to qualified recipients and payments made to such recipients in return for goods and services.”5 Under the case law that’s developed, a transfer of cash or property will be considered a “contribution or gift” under Section 170(c) when it’s made: (1) with a donative intent; (2) voluntarily; and (3) without the receipt of full and adequate consideration.6
Donative Intent Generally
A taxpayer must have a donative intent for a transfer to a qualified charity to constitute a contribution or gift for purposes of Section 170(c). When the transfer to a charitable organization lacks donative intent but is impelled primarily by some expected benefit to the donor beyond the mere satisfaction that flows from the performance of a generous act, it isn’t considered a contribution or gift. Therefore, no charitable deduction is allowable when the donor has an expectation of receiving some substantial benefit by virtue of making a transfer to charity, even though the expectation isn’t supported by an enforceable contractual claim or the benefit isn’t received directly from the charity. The historical test for “donative intent” requires that the transfer be an expression of a “detached and disinterested generosity.” This test was originally formulated by the U.S. Supreme Court in the famous Duberstein case,7 involving the issue of whether a purported gift of a Cadillac from one business associate to another was a nontaxable gift or taxable compensation.8
Quid Pro Quo Test
Under the Duberstein“detached and disinterested generosity” test, the most critical consideration is the transferor’s intention. In lieu of the Duberstein test, which focuses on motive alone, courts have more recently tended to focus on an objective standard by applying a quid pro quo test. Under that test, a transfer to a charitable organization will be considered to lack donative intent and, therefore, not be considered a gift or contribution, when the transferor receives or expects to receive a financial return commensurate with the value transferred to the charity.9
In ascertaining whether a given payment is made with the expectation of a quid pro quo, the courts have examined the external features of the transaction in question, rather than examining the transferor’s subjective intention.10 This practice has the advantage of obviating the need for the Internal Revenue Service to conduct imprecise inquiries into the motivations of individual taxpayers, given that the focus of the quid pro quo test isn’t on the taxpayer’s motivation. Instead, the test is based on an objective examination, based on all the surrounding facts and circumstances, as to whether the transfer to charity is being made by the donor in exchange for a commensurate benefit.
Dual Character Payments
The courts, as well as the IRS, have recognized that a payment to a charity may have a dual character as part contribution and part payment for goods or services.11 The Treasury regulations adopt a consistent approach, whereby no part of a payment that a taxpayer makes to a charitable organization that’s in consideration for goods or services is a contribution or gift within the meaning of Section 170 unless the taxpayer: (1) intends to make a payment in an amount that exceeds the FMV of the goods and services received in exchange, and (2) makes a payment in an amount that exceeds the value of such goods or services.12
Authority
In Chief Counsel Advice (CCA) 201105010, pursuant to a state program awarding state tax credits in return for charitable contributions earmarked for economic development, the taxpayers submitted applications to the State Department of Economic Development for approval to make a certain amount of the charitable contributions under the program. The applications were accepted, and the taxpayers were granted state income tax credits equal to a specified percentage of the approved contributions. Pursuant to the parameters of the program, the taxpayers used a certain amount of the state income tax credit to offset their Year 1 state income tax liability; sold a certain amount of the state income tax credits to other individuals; and carried forward the remaining amount of the state income tax credits to future years. The IRS ruled that the state income tax credits weren’t treated as benefits received by the donor that would reduce the amount of the charitable contribution deduction, stating that “the payment is considered a charitable contribution under § 170, not a payment of tax possibly deductible under § 164.”
In its analysis in CCA 201105010, the IRS specifically acknowledged the firmly established legal principle that serves to eliminate or reduce an otherwise available charitable income tax deduction when the contribution is made in return for specified monetary consideration. In determining that the tax credits provided in return for the charitable contribution didn’t constitute a quid pro quo that would reduce or eliminate any part of the charitable income tax deduction, the IRS, citing federal case law,13 stated that the “tax benefit of a federal or state charitable contribution deduction is not regarded as a return benefit that negates charitable intent, reducing or eliminating the deduction itself.”
It’s interesting that, for purposes of applying the quid pro quo rules of Section 170 in CCA 201105010, the IRS equated the benefit of the income tax savings resulting from a federal income deduction to the benefit of a state income tax credit, so that in both cases, the charitable deduction otherwise available under Section 170(a) isn’t reduced by the resulting tax savings. This was the case notwithstanding that it would likely have been more favorable from the perspective of the IRS to treat the charitable deduction as the equivalent of a state income tax payment because, unlike a charitable contribution deduction, a state income tax payment is subject to the alternative minimum tax, potentially exposing the taxpayer to greater federal taxes. The approach taken in CCA 201105010 appears to have been adopted by the Tax Court in Tempel v. Comm’r,14 which may provide support for the allowance of the deduction.
Note, of course, that CCA 201105010 may not be used or cited as precedent. And, note that the approach applied in CCA 201105010 wasn’t absolute, as the IRS specifically stated, as indicated above, that “[t]here may be unusual circumstances in which it would be appropriate to recharacterize a payment of cash or property that was, in form, a charitable contribution as, in substance, a satisfaction of tax liability.”
Issues to Consider
While charitable contributions made to a state for exclusively public purposes are generally deductible for federal income tax purposes under Section 170(a), when state tax credits are provided by a state under a program to encourage a charitable contribution not to one or more specified third-party charities that a donor chooses to support, but to the very state (or locality) providing the tax credits, greater scrutiny appears warranted in the context of Section 170(a). Even accepting the position that a state tax benefit provided to encourage charitable giving doesn’t result in a quid pro quo transaction for Section 170(a) purposes, a charitable deduction is still premised on the transfer being motivated by a charitable intent and made on a voluntary basis.
Contributions to one or more third-party charities chosen by a donor, even under a state program providing state tax benefits to encourage such contributions, presumably should be considered to be motivated by a charitable intent and made on a voluntary basis. In this situation, the donor has a choice that may be freely exercised: Contribute to a charity the donor seeks to support or pay taxes to the state. When, however, a donor makes a purported contribution to a qualified charity of an amount that he would otherwise be required or expected to pay to the very same organization, the actual substance of the payment will control the characterization of the payment for federal income tax purposes. In Revenue Ruling 83-104, for example, a private school described in Section 170(c) requested parents to contribute $400x to the school for each of their children enrolled in the school. Parents who didn’t make the $400x contribution were required to pay $400x tuition for each child enrolled in the school. Parents who neither made the contribution nor paid tuition couldn’t enroll a child in the school. The IRS, citing federal case law and legislative history of Section 170, ruled that because a parent had to either make the contribution or pay the tuition charge, the “payment is not voluntary and no [charitable] deduction is allowed.” The IRS stated that “a plan allowing taxpayers either to pay tuition or to make ‘contributions’ in exchange for schooling” creates a “presumption that the payment is not a charitable contribution.” In the same ruling, the IRS stated that “factors suggesting that a contribution policy has been created as a means of avoiding the characterization of payments as tuition” are indicative of the payments not being a charitable contribution.
Thus, if a purported charitable contribution made by a resident of a state is merely a substitute for a tax payment otherwise required to be made to the state if the contribution isn’t made, the characterization of such a payment as a charitable contribution for federal income tax purposes will be in jeopardy, particularly when it’s made under a legislative plan adopted for the very purpose of avoiding the characterization of the payments as taxes. Indeed, this situation may fall within the language of CCA 201105010 that there “may be unusual circumstances in which it would be appropriate to recharacterize a payment of cash or property that was, in form, a charitable contribution as, in substance, a satisfaction of tax liability.” The Treasury has very broad discretion under the so-called Chevron doctrine, based on the 1984 Supreme Court decision in Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc.,15 to issue a regulation that could provide that no deduction for a charitable contribution would be allowed to the extent a credit against a state or local tax is allowed.
It would appear that a state seeking to adopt a legislative proposal to recast SALT payments as charitable contributions will be best situated under the Section 170 tax regime if it actually gives its residents discretion as to the public purposes to which their contributions will be used, so that the contributions aren’t essentially equivalent to a tax payment that would otherwise be required to be paid to the state but, instead, may be considered motivated by some form of charitable intent and to be made on a voluntary basis. This could include, for example, providing the donor with a choice of allocating a contribution among the wide array of activities, operations, programs and functions carried out by the state for exclusively public purposes that the donor seeks to support and creating separate funds dedicated for such purposes. Presumably, the greater the choice a donor has with respect to the use of a purported charitable contribution to a state and the less the contribution is used in the same manner as an ordinary tax payment that would otherwise be required to be made, the better the position that the contribution is motivated by charitable intent and is voluntary and isn’t merely a substituted tax payment. Of course, such a choice of funding provided to a potential donor must be reconciled with the financial and budgetary needs of the state.
Endnotes
1. P.L. 115-97, 131 Stat. 2054.
2. Milton Ezrati, “High-Tax States Reach for Gimmicks,” Forbes (Feb. 16, 2018).
3. Continental Illinois National Bank & Trust Co. of Chicago v. United States, 403 F.2d 721 (Ct. Cl. 1968). The court in this case recognized that many activities of government are in no sense charitable and, in fact, are generally available only to paying customers, stating that these are “proprietary activities and include the operation of golf courses, wharves, market places, transportation facilities, and such public utilities as gas, water, and electric systems. It’s a meaningful distinction to say that while these activities are not ‘charitable,’ they nevertheless are for public purposes, as the local government conceives the needs of its public.”
4. See, e.g., Murphy, 54 T.C. 249 (1970); Estate of Wood, 31 T.C. 1143 (1959).
5. Hernandez v. Commissioner, 490 U.S. 680, 690 (1989). See also U.S. v. American Bar Endowment, 477 U.S. 105 (1986).
6. See, e.g., U.S. v. American Bar Endowment, ibid. (“[T]he sine qua non of a charitable contribution is a transfer of money or property without adequate consideration. The taxpayer, therefore, must at a minimum demonstrate that he purposely contributed money or property in excess of the value of any benefit he received in return”); DeJong v. Comm’r, 36 T.C. 896 (1961), aff’d, 309 F.2d 373 (9th Cir. 1962) (“A gift is generally defined as a voluntary transfer of property by the owner to another without consideration thereof”); Revenue Ruling 71-112 (“A gift is generally defined as a voluntary transfer of property by its owner to another with donative intent and without consideration”).
7. Comm’r v. Duberstein, 363 U.S. 278 (1960).
8. In Duberstein, the Tax Court, T.C. Memo. 1958-4, and later the U.S. Supreme Court, agreed with the position of the Internal Revenue Service that the value of the car was taxable compensation rather than a nontaxable gift. In reaching its conclusion, the Supreme Court placed great reliance on the Tax Court’s factual finding that the gift wasn’t motivated by “detached and disinterested generosity,” stating that “it was at bottom a recompense for Duberstein’s past services, or an inducement for him to be of further service in the future.” The fact that there was no specific legal obligation to make the transfer of the car was irrelevant, as the test of whether a gift occurred, according to the Court, was based on the motivation of the taxpayer in making the transfer.
9. See, e.g., Transamerica Corp. v. U.S., 15 Ct. Cl. 420 (1988); Neher v. Comm’r, 852 F.2d 848 (6th Cir. 1988); Haak v. U.S., 451 F. Supp. 1087 (W.D. Mich. 1978): Rev. Rul. 86-63.
10. See, e.g., Singer Co. v. U.S., 449 F.2d 413 (Ct. Cl. 1971); U.S. v. American Bar Endowment, supra note 5; Hernandez v. Comm’r, supra note 5.
11. See, e.g., Rev. Rul. 68-432 (noting possibility that payment to charitable organization may have “dual character”); Rev. Rul. 67-246 (price of ticket to charity ball deductible to extent it exceeds market value of admission); see also HR Rep. No. 103-111, at 785 (1993) (a charitable deduction is limited to the amount exceeding the value of the consideration received).
12. Treasury Regulations Section 1.170A-1(h)(1).
13. See McLennan v. U.S., 23 Cl. Ct. 99 (1991) (“a donation of property for the exclusive purpose of receiving a tax deduction does not vitiate the charitable nature of the contribution”); Skripak v. Comm’r, 84 T.C. 285, 319 (1985) (“However, as stated above, the deduction for charitable contributions was intended to provide a tax incentive for taxpayers to support charities. A taxpayer’s desire to avoid or eliminate taxes by contributing cash or property to charities cannot be used as a basis for disallowing the deduction for the charitable deduction”); Allen v. Comm’r, 92 T.C. 1, 7 (1989), aff’d, 925 F.2d 348 (9th Cir. 1991); see Browning v. Comm’r, 109 T.C. 303 (1997) (value of state and federal tax benefits not part of the amount realized from a bargain sale of donated property).
14. Tempel v. Comm’r, 136 T.C. 341 (2011).
15. Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984).