Charitable SALT Workarounds After the Demise of Chevron Deference

From Windes

When the TCJA sunsets next year, the limitation on SALT deductions will expire, eliminating the need for charitable SALT cap workarounds.  House Republicans have formed themselves into a circular firing squad trying to decide whether to join with Democrats who want to let the limitation expire.  I'm putting my money on Congress increasing the limit from $10,000 to maybe $20,000 but otherwise extending the limitation.  Raising the limit would be a compromise but would mean SALT workarounds remain viable.  As I reported earlier this year, though, the Service has put its foot down on SALT Workarounds via regs issued in 2019:

In response to the new limitation under section 164(b)(6), some taxpayers are seeking to pursue tax planning strategies with the goal of avoiding or mitigating the limitation. These strategies rely on state and local tax credit programs under which states provide tax credits in return for contributions by taxpayers to or for the use of certain entities described in section 170(c). The use of state or local tax credits to incentivize charitable giving has become increasingly common over the past 20 years. Moreover, since the enactment of the limitation under section 164(b)(6), states and local governments have created additional programs intended to work around the new limitation on the deduction of state and local taxes.

Here is the basic skinny on SALT workarounds.  Instead of paying state taxes not deductible on federal returns, a state taxpayer makes a charitable contribution equal to the taxes that would otherwise have been paid.  It's a wash for the state, especially if the "contribution" is made to a government entity.  But the donor gets to take a federal deduction for the contribution equal to the amount that would otherwise been called taxes and disallowed by IRC 164.  For example, instead of paying $30,000 in state taxes, only $10,000 of which would have been deducted at the federal level, a state taxpayer pays $10,000 in state taxes and #20,000 as a charitable contribution.  As a result, the entire $30,000 is deductible at the federal level -- $10,000 as state taxes under IRC 164, and $20,000 as a charitable contribution under IRC 170.  

Treasury enacted Regulation 1.170A-1(h)(3) to shut it all down:

Payments resulting in state or local tax benefits —(i) State or local tax credits. Except as provided in paragraph (h)(3)(vi) of this section, if a taxpayer makes a payment or transfers property to or for the use of an entity described in section 170(c), the amount of the taxpayer's charitable contribution deduction under section 170(a) is reduced by the amount of any state or local tax credit that the taxpayer receives or expects to receive in consideration for the taxpayer's payment or transfer.

New York, New Jersey and Connecticut challenged the regulation but lost at the district court. The argument is that there is no legislative authority for the proposition that receipt of a state tax credit is a "quid pro quo" in exchange for a charitable contribution but that is Treasury's underlying and dubious reasoning. There is plenty of case law, and it makes economic sense, that only the amount given in excess of that received constitutes a charitable contribution.  But there is no legislative or judicial authority for the proposition that a tax concession is a return benefit reducing the charitable contribution deduction.  It would probably take an Oppenheimer to figure out the total contribution if we treated every tax concession as a return benefit.  I'm no Oppenheimer, but I imagine the deduction would always be zero once the math is all said and done.  Except the regulation applies to the benefit received from a state or local government, not a federal tax benefit under 170.  

The district court relied on Chevron deference to uphold the regulation as a reasonable interpretation of an allegedly ambiguous state.  But we all know what happened later last summer to Chevron deference.  So the three States have a pretty good shot on appeal, now that Chevron deference is a relic of history. I expect a remand, if not a complete reversal.  Here is the introduction to their opening brief before the Second Circuit Court of Appeals:

INTRODUCTION

For more than 100 years, Congress has sought to incentivize charitable giving by offering a tax deduction for charitable contributions. In reliance on this deduction, over 30 States developed numerous programs offering tax credits to taxpayers who donated to qualifying organizations. Taxpayers, in turn, have been entitled to deduct the full value of their charitable contribution from their federal taxes, without having to subtract the value of any federal, state, or local tax benefits they had received for the contribution. Courts had upheld this practice, as did the Internal Revenue Service (“IRS”), which long agreed the federal charitable contribution deduction need not be offset by resulting tax benefits—including state tax credits. Congress repeatedly amended the Internal Revenue Code without disturbing this understanding.

But in 2019, the IRS broke from that century-long consensus. Departing from its prior understanding of the federal charitable deduction, the agency for the first time published a rule requiring taxpayers to subtract credits they receive against state and local tax (“SALT”) liability from their federal charitable contribution deduction. See Contributions in Exchange for State or Local Tax Credits, 84 Fed. Reg. 27513 (June 13, 2019) (“Final Rule”). That departure undercut the financial incentives that taxpayers had to contribute to States’ charitable tax credit programs, and its results were striking and predictable. In the wake of Congress’s decision to cap the SALT deduction, Connecticut, New Jersey, and New York enacted statutes that allowed residents to receive substantial tax credits when they make contributions to public funds. But contributions to New York’s fund ground to a halt once the Final Rule issued. Seeing the writing on the wall, localities in New Jersey and Connecticut abandoned plans to establish similar funds. The Final Rule thus deprives all three States of tax revenues they would otherwise put to public use, including supporting education and health care services. The U.S. District Court for the Southern District of New York (Gardephe, J.) agreed that at least one State had standing to challenge the Final Rule, but rejected the States’ challenges to the rule on the merits. This Court should reverse.

First, the Final Rule is contrary to Section 170 of the Internal Revenue Code, the federal provision governing charitable deductions. Section 170 requires the IRS to “allow[] as a deduction any charitable contribution,” which Congress defined as a “contribution or gift to or for the use of” qualified entities, including to “State[s]” and their “political subdivision[s].” 26 U.S.C. § 170(a), (c). Nowhere in Section 170’s text did Congress disclaim an otherwise-qualifying contribution when a donor received a tax benefit, including in the form of a tax credit. For good reason: as this Court has previously explained, “[i]f the motivation to receive a tax benefit deprived a gift of its charitable nature under Section 170, virtually no charitable gifts would be deductible,” as the federal charitable deduction itself provides such an incentive. Scheidelman v. C.I.R., 682 F.3d 189, 200 (2d Cir. 2012). The district court erred in simply deferring to the IRS’s interpretation of Section 170, and the court failed to ask whether the IRS’s construction is in fact the “best” reading, Loper Bright Enterprises v. Raimondo, 144 S. Ct. 2244, 2266 (2024). It is not: whatever the merits of the IRS’s policy goals, the Final Rule is inconsistent with Section 170’s text.

Second, the Final Rule is arbitrary and capricious. It distinguishes state tax credits, which are not deductible, and state and federal tax deductions, which are, even though credits and deductions reflect similar benefits that incentivize charitable giving. It also exempts donors from accounting for tax credits that do not exceed 15 percent of the underlying contribution—meaning a taxpayer who makes a donation triggering a state tax credit worth 15 percent may fully deduct that contribution, and need not subtract any of the credit’s value, while the very same taxpayer who makes a contribution yielding a tax credit worth 16 percent must subtract that credit’s entire value. The Final Rule attempts to muster policy justifications for these distinctions, but never explains how to square its approach with the statutory text. Because the Final Rule is inconsistent with the best reading of Section 170, and because the IRS’s explanations for the Final Rule’s distinctions fall short, this Court should reverse.

darryll k. jones