One of the biggest revenue-raisers in the Tax Cuts and Jobs Act (TCJA) is a strict limit on the federal deduction for state and local taxes. The new law caps the state and local tax (SALT) deduction for individuals to $10,000 per year for all state and local taxes combined. The limit applies to income taxes, real property taxes, personal property taxes, and sales taxes, which previously were an unlimited itemized deduction. In response to this change, states are looking at different ways to circumvent the limitation. One way is to allow taxpayers to make deductible “charitable contributions” to the state in lieu of income tax payments. To stop these efforts, the IRS and Treasury Department plan to issue regulations that disallow a federal charitable contribution deduction for these “donations” even if they go into state-sponsored charitable funds.
State Labels Don’t Matter
IRS Notice 2018-54 warns against state legislative proposals that “allow taxpayers to characterize … transfers as fully deductible charitable contributions for federal income tax purposes, while using the same transfers to satisfy state or local tax liabilities.” The Notice reminds taxpayers that “federal law controls the characterization of payments for federal income tax purposes” and explains that the IRS will use “substance over form principles” to evaluate the character of payments to funds or groups controlled or designated by states. At the federal level, charitable contributions are judged by the taxpayer’s charitable intent to give without expectation of getting something in return. The IRS’s challenge to state donations is likely to be based on the benefits that taxpayers receive from participation in these state programs.
New State Law Workarounds
New York, New Jersey, and Connecticut already have passed legislation to convert taxes into charitable contributions or other deductible payments. New York, in its budget bill, included a provision to convert its state income tax to a payroll tax. Under this plan, a company remits a voluntary payroll tax for its employees in return for a tax credit against its employees’ state income tax liability. The New York law also sets up funds for various public purposes under which taxpayers make charitable contributions in return for a credit against income tax liability. The Connecticut legislation takes a different tack, imposing a new income tax on most pass-through businesses at the entity level which would be offset by a state credit at the personal tax level. The federal SALT deduction limitation does not apply to taxes related to a taxpayer’s trade or business, so Connecticut’s entity-level tax would be deductible under the TCJA.
The fate of these state tax workarounds is uncertain given the IRS warning and forthcoming regulations. The Notice appears directed at exactly these types of practices, but what about state charitable contribution laws that predate the TCJA?
Are Pre-Existing State Donation Plans at Risk?
The state laws discussed above were passed in 2018 specifically to help state taxpayers to get around the federal SALT deduction limit. However, there are laws in many states that existed prior to enactment of the TCJA, and it remains to be seen how the IRS will distinguish between legitimate state plans in place before the SALT limitation was enacted and new state legislation specifically intended to thwart the SALT limitation. For example, many states, including Georgia, already have arrangements in which taxpayers get a credit against their state taxes for donations to scholarship funds and rural hospitals, and the donations so far have been tax deductible at the federal level.
Under the Georgia scholarship program, taxpayers can pledge up to $1,000 for an individual or $2,500 for a married couple to specific private schools and get a state tax credit off their state income tax liability. The money goes through nonprofit scholarship organizations that give it to parents of eligible children who plan to attend private schools. Georgia also allows a credit against state tax liability for donations to rural hospitals under the Georgia Hospital HEART Program and notes in the FAQs for the program that taxpayers can deduct the hospital donations on their federal returns. (See FD Insights article on the Georgia rural hospital credit program.)
The big question here is whether the IRS regulations will invalidate charitable contributions only if the states’ actions were specifically intended to affect federal tax liability. This approach would put the IRS in a position of determining the intent of state law, not an easy thing to do. If the IRS regulations are too broad, taxpayers who contribute under pre-existing programs that up until now qualified for federal charitable deductions could lose out. No matter how the IRS writes the new rules, it is likely the agency will face litigation over its attempts to deny deductions for state-sanctioned payments. The vetting process is just beginning, and the issue may not be resolved for a long time.
About the Author
Lucia Nasuti Smeal is a guest writer on tax topics for Frazier & Deeter. Smeal is an attorney, a tax professor with Georgia State University’s J. Mack Robinson College of Business, and former editor of Tax Notes Today, published by Tax Analysts. Smeal also worked as a legislative analyst for the Congressional Research Service and is a former member of the U.S. House Periodical Press Corps. She is a frequent speaker on current tax developments.