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IRS Proposal Would Sink States' Tax Deduction Workarounds

The IRS building in Washington, D.C.

The IRS building in Washington, D.C. Shutterstock

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The U.S. Treasury Department and IRS released their highly anticipated regulatory proposal on Thursday.

Proposed regulations the U.S. Treasury Department and IRS issued Thursday would block state attempts to provide taxpayers with a way around the recently imposed cap on state and local tax deductions.

Last year's Republican-led tax overhaul capped the federal deduction that individual taxpayers can claim for certain state and local taxes they pay at $10,000. Some states have sought to create a pathway for circumventing this cap by relying on charitable contributions, which remain fully deductible under the federal tax code.

These workarounds involved soliciting contributions to help pay for public services, and then allowing people to claim a state tax credit on par with the contributions to lower the state taxes they owe.

Connecticut, Oregon, New Jersey and New York were among the states that moved ahead with these types of policies.

In New Jersey for instance, Gov. Phil Murphy, a Democrat, signed legislation in May to allow taxpayers to donate to a charitable fund set up by their municipality, county or school district and in return receive a property tax credit of up to 90 percent of their donation.

The newly proposed federal regulations would undermine these types of state policies.

Under the proposal, taxpayers would have to reduce the charitable deductions they claim on their federal tax returns by an amount that’s aligned with any state or local tax credit they expect to receive.

"Congress limited the deduction for state and local taxes that predominantly benefited high-income earners to help pay for major tax cuts for American families,” said Treasury Secretary Steven T. Mnuchin.  “The proposed rule will uphold that limitation by preventing attempts to convert tax payments into charitable contributions."

The IRS and Treasury offered this example: “if a state grants a 70 percent state tax credit and the taxpayer pays $1,000 to an eligible entity, the taxpayer receives a $700 state tax credit. The taxpayer must reduce the $1,000 contribution by the $700 state tax credit."

This would leave an allowable charitable contribution deduction of $300 on the taxpayer’s federal income tax return.

There is an exception that would allow taxpayers to claim a full charitable tax deduction on their federal tax return if a state or local tax credit they receive is no more than 15 percent of their donation. So, for example, a person who makes a $1,000 donation would not have to lower it on their return if the credit they receive is $150 or less.

A twist with the proposed regulations is that they would affect certain tax credit programs in effect before the attempted state and local tax, or SALT, workarounds emerged. Those programs gave people access to state tax credits after they made contributions that helped buoy private schools and are on the books in Alabama, Arizona and Georgia, as well as other states.

U.S. Rep. Kevin Brady, the Texas Republican who chairs the House Ways & Means Committee and one of the main architects of last year’s tax legislation, applauded the proposal.

“These Treasury regulations rightly close the door on improper tax evasion schemes conjured up by state and local politicians who insist on brutally taxing local families and businesses,” he said.

But top Ways & Means Democrat, U.S. Rep. Richard Neal, of Massachusetts, knocked the proposal. “The Administration’s new regulations block affected states’ attempts to cope with this significant change and protect residents from double taxation,” he said.

Protecting the full state and local tax deduction was a priority for many state and local government groups during last year's tax debate.

One of their main arguments against chopping the deduction was that doing so would make it more difficult to levy taxes at the state and local level to pay for services and infrastructure. But much of the discussion was framed in a way that pitted predominantly Democratic and higher tax states against those that lean Republican.

Experts at the Urban-Brookings Tax Policy Center have noted that, in 2018, 96 percent of the additional tax from the limitation of the SALT deduction falls on the top 20 percent of taxpayers and 57 percent on the top one percent.

The SALT cap also promises to raise nearly $650 billion for the federal government over 10 years to help offset other tax policy changes, including corporate and individual rate cuts.

New York Gov. Andrew Cuomo, a Democrat and a vocal critic of the federal limits imposed on the SALT deductions, called the proposed regulations "politically motivated."

"We will not stand for this abuse of government power," Cuomo said. "We are confident that the recently enacted opportunities for charitable contributions to New York State and local governments are consistent with federal law and follow well-established precedent." 

He added that the state would consider litigation in its effort to "fight back" over its tax policies.

New York is already involved in a lawsuit against the Treasury Department and the IRS over the cap imposed on the SALT deduction. Connecticut, Maryland and New Jersey joined the state last month in filing the suit, which argues that the cap interferes with the ability of the states to guide their own fiscal policies.

New Jersey Attorney General Gurbir Grewal on Thursday echoed Cuomo's threat of further legal action in response to the regulations. "We’ve already sued the Administration once over the SALT tax cap, and we’ll do it again if we have to," he said.

The publication of the proposed regulations on Friday will initiate a 45-day comment period. They are set to apply to contributions made after August 27.

In addition to pushback from states chafing over the SALT cap, the proposal is likely to encounter opposition from groups that want to see tax credits supporting private schools protected.

Mnuchin said Treasury believes "the proposed rule will have no impact on federal tax benefits for donations to school choice programs for about 99 percent of taxpayers compared to prior law.”

But others thought they would have a direct impact on tax credit scholarship programs, which are similar to vouchers, that some states have adopted in recent years.

John Schilling, president of the American Federation for Children, said the proposed IRS rule "will harm state tax credit scholarship programs that are currently benefitting more than 250,000 students."

Brady urged states with tax credit programs that predate the enactment of last year's tax law to "review the proposed regulations and make full use of the comment period." He said this "will be valuable as Treasury continues to work to preserve legitimate charitable programs while preventing tax evasion by some states."

Programs involving the private school tax credits date back to the late 1990s in Arizona. The state constitution there prevents public money from going to religious schools, which created complications for issuing vouchers for private school tuition. Instead, the state turned to nonprofit groups to accept donations and offer stipends.

In exchange for making donations, people became eligible for a state tax credit, offsetting the donation. And the contribution could be deducted on their federal taxes. These programs have since evolved.

Carl Davis, director of research at the Institute on Taxation and Economic Policy explained by phone on Thursday that the proposed regulations do not contain a carve out for these types of private school tax credit programs. "They're not drawing lines," he said.

"The pre-existing credits are affected in the same way," Davis added.

He said that in some ways the "blue state" SALT workarounds amounted to adapted versions of the private education tax credits, which have been popular in Republican states.

"This type of improvement to the federal charitable deduction, measuring what's real charity and what's not, was long overdue," he said. "We've seen people abusing these large state tax credits for many years," Davis added. "This is bringing that party to an end."

This story has been updated with additional comment and other information.

Bill Lucia is a Senior Reporter for Government Executive's Route Fifty and is based in Washington, D.C.

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