Yesterday, the IRS issued a notice warning states that are contemplating one workaround to the Tax Cut and Jobs Act’s (TCJA) $10,000 annual limit on individuals’ ability to deduct state and local taxes (SALT) on their federal tax returns: Slow down.
Connecticut, Oregon, New Jersey, and New York recently enacted laws to designate funds to solicit private contributions to support public services, such as health care and education. The states will permit their residents to credit nearly all their contributions to these funds against their state tax liabilities. The states anticipated that the contributions would be deductible against federal taxable income as charitable gifts while payment of state taxes directly might not be deductible. Although the TCJA capped SALT deductions at $10,000 annually, it did not cap charitable contribution deductions. Other states are considering similar arrangements.
Yesterday, the IRS said it will propose regulations to address the federal income tax treatment of contributions to these funds. It emphasized that federal tax law governs whether contributions are deductible. The law, it said, is informed by “substance-over-form principles.” In other words, even if the states call the payments deductible charitable gifts, if the IRS determines that they are, in effect, state or local taxes, they may not be deductible against federal taxable income.
Some believe contributions to funds like these would be charitable in nature, and therefore deductible. Others disagree. The IRS appears to be in the latter camp. But because the document is only an IRS notice, we can only speculate on the final position. By sending the notice, the Service is also suggesting it may be some time before it issues formal guidance.
The IRS notice is likely only one step in what could be a protracted legal and political battle between some states and the IRS. However, if the IRS promulgates its interpretation through regulations, the IRS likely would be given great deference by the courts. Taxpayers might argue the agency is wrong, based on its earlier guidance--and its lack of challenge to prior charitable giving programs that support schools and parks. But, to win, a taxpayer would need to demonstrate that the future regulations are arbitrary or capricious, which is difficult.
The IRS was silent on other workarounds, such as the New York law that gives employers the option to pay a 5 percent payroll taxes on annual wages, which employees could credit against their state tax obligations. In effect, employers could pay a tax deductible payroll tax in lieu of workers paying some non-deductible income tax. Firms that make this election would likely reduce wages, but workers would receive a tax credit to compensate them for any decline in their take-home pay. Perhaps the payroll workaround now will be more attractive. However, the payroll tax raises different administrative problems—and some question whether employers and rank-and-file employees will embrace the concept.
