A notice of impending federal rules to address state workarounds to the new state and local tax deduction cap is expected to temporarily discourage taxpayers and practitioners from using charitable deductions to circumvent the cap, but it’s unclear whether the states or the IRS will prevail.
“Most practitioners that I spoke to were taking a wait-and-see approach to see what happens next,” said Daniel Rosen of Baker McKenzie. But “there’s a general anticipation that there will be litigation” by states that will give greater certainty to taxpayers on how to proceed in the near term.
Tax law experts argue that long-standing state programs already allow taxpayers to claim the federal charitable deduction for donations made to state funds in return for tax benefits and that those programs have been upheld in past IRS memos, which puts the agency in a potentially tenuous position and complicates any effort to craft regs that would affect only recent moves to counter the Tax Cuts and Jobs Act’s (P.L. 115-97) SALT cap.
Practitioners React
The new $10,000 cap on the SALT deduction threatens primarily blue states’ progressive tax regimes because it could pressure their high earners to engage in aggressive state tax planning or move to lower-tax states. Proponents of the cap argue that those blue states have been using the SALT deduction to shift the cost of their tax regimes onto the federal government, and through it to other states’ taxpayers.
Some progressive-tax states have responded to the SALT deduction cap by providing a state tax credit in return for donations to various state funds. A donor can then claim a federal charitable tax deduction on the donation — an amount that could be in excess of the cap. New York, New Jersey, Connecticut, and Oregon all have approved such a workaround.
In Notice 2018-54, 2018-24 IRB 750, released May 23, the IRS announced that it intends to issue regulations to curtail efforts to get around the SALT cap. “The proposed regulations will make clear that the requirements of the Internal Revenue Code, informed by substance-over-form principles, govern the federal income tax treatment of” donations to state funds, the notice stated.
Practitioners said the announcement was hardly unexpected, given how openly state lawmakers have characterized their proposals as a means to circumvent the cap and in light of Treasury Secretary Steven Mnuchin’s criticism of those efforts. “I think that the IRS announcement will deter some taxpayers from utilizing the programs, especially where they’ve been very highly publicized — like New York and New Jersey,” said Elizabeth Norman of Nutter McClennen & Fish LLP.
The IRS notice didn’t indicate how the agency will vet charitable deductions. Practitioners said it mainly outlined the agency’s intent to counter state SALT workarounds and that the notice was designed to warn taxpayers and states against the workarounds without requiring any actual rule to be promulgated, buying the agency time. Carl Davis of the Institute on Taxation and Economic Policy (ITEP) said the IRS may attempt to have rules out by the end of the year, but “it’s a very thorny issue and it won’t be easy.”
“Even if they do succeed, whatever they implement is going to be challenged in court,” Davis said. “If it were an easy fix, the details would have been announced.”
Sources say the rulemaking might take closer to two years, given the amount of work the IRS already has on its plate. But that length of time doesn’t reassure practitioners because taxpayers who choose to use the states’ workarounds would bear the risk of audits and penalties if their deductions were ruled improper. The notice could make it easier for the IRS to have the final rules apply retroactively because it could assert that taxpayers were forewarned.
While most taxpayers may shy away from using the SALT workaround, practitioners say there will be some early adopters. Some of them may claim the deduction on their returns, while others “are just as likely to pay the tax and then make a refund petition” to avoid an IRS audit and interest and penalties, although they could still face an erroneous refund penalty, Rosen said.
Darien Shanske, a law professor at the University of California, Davis, and one of the early proponents of the charitable tax deduction strategy, said some taxpayers will try out the workarounds despite the risk because the effective burden of their state taxes will increase considerably under the TCJA’s SALT cap. “A lot of taxpayers are not looking to do something that is going to antagonize the IRS . . . but at the same time, they also are looking to reduce their taxes,” Shanske said.
States Respond
Lawmakers in states that have adopted or are considering SALT workarounds responded harshly to the IRS notice, signaling their intent to fight its interpretation of the law. “The IRS should not be used as a political weapon,” New York Gov. Andrew Cuomo (D) said in a May 23 statement, promising to “fight against this economic missile . . . with every fiber of our being.” New Jersey Gov. Phil Murphy (D) slammed the IRS’s intent to “permit certain states to allow for charitable deductions, but not others that are following the same principles.”
California Sen. Kevin de León (D), who authored a bill (S.B. 227) to provide state income tax credits for donations to a new state fund, said in an emailed statement that the IRS’s announcement “essentially acknowledged that our proposal is on solid legal ground” because the agency “wouldn’t need a new regulation if they felt our proposal fell outside [the] current test for charitable deductions.”
“Now they want to rewrite existing IRS policy to attack California and New York. We’re confident that regardless of whatever they come up with, our proposal passes muster under an economic substance analysis and will stand up in court,” de León said.
New York and New Jersey could be exploring pre-enforcement challenges, sources say. Although there’s now no regulation for them to litigate, the states could seek a declaratory judgment on the legal issues regarding donations, state tax credits, and the federal charitable deduction. “I would expect litigation in response to the notice — if I was the state of New Jersey or New York, I’d be considering litigation,” Rosen said, adding that states may also file Freedom of Information Act litigation “regarding the process giving rise to the notice.”
If the IRS seeks to counter the states’ suits by arguing that its notice isn’t final, that could buoy the SALT cap workarounds in the public eye, practitioners say. However, states would still face challenges in taking the matter to court. Jeffrey Vesely of Pillsbury Winthrop Shaw Pittman LLP said that “you’d run into procedural issues” in trying to get a court to consider a challenge to the IRS based on its notice.
Shanske agreed, but said there is precedent for states to challenge the federal government based on how federal rules could affect their tax regimes, citing South Carolina v. Regan, 465 U.S. 367 (1984). “That was a case involving a change in federal law related to state bonds . . . and South Carolina wanted to get into court earlier rather than later to ascertain whether the change was constitutional,” he said. In its decision in Regan, the U.S. Supreme Court held that the state could sue to overturn the law, although it ultimately upheld the federal law in a separate decision.
Shanske said states may have a workable argument for seeking a preemptive challenge: that the IRS notice creates uncertainty that could affect states’ tax regimes, but frees the IRS of any immediate obligation to clarify its legal basis for countering their SALT cap workarounds. He noted that the IRS has historically allowed taxpayers to claim the federal charitable deduction for donations to private charities and state programs for which the taxpayers also received state tax credits. Previous IRS memos have held that awarding those credits doesn’t necessarily create a quid pro quo scenario that renders the donations non-charitable for federal tax purposes.
Davis said the IRS will have a difficult time arguing that there’s a distinction between the new SALT cap workarounds and similar preexisting state programs. Notably, many such programs pay for private tuition and are strongly backed by many conservative politicians.
“The question is, given how long the IRS has been allowing similar shenanigans to go on with private school voucher tax credits, will they now be able to reverse course?” Davis said. “There’s no precedent for reducing taxpayers’ charitable deductions by the amount of state tax benefits they received.”
Backers of those preexisting charitable tax deduction programs have been pointing to them as ways to get around the SALT deduction cap. “Programs in Alabama and Pennsylvania . . . have been promoted as workarounds or ways to get around the SALT cap,” Norman said. “It’s going to be very difficult to distinguish between the programs” that predate the TCJA and those created in direct response to the new SALT cap, she added.
Rulemaking Prospects Unclear
Any formal IRS push to stymie taxpayers’ efforts to claim the federal charitable deduction through the use of states’ SALT workarounds will face an uphill battle. “Are they going to make a charitable or donative intent” test? Rosen asked. “You can’t say charitable intent is a controlling factor just for regimes in New York and New Jersey” because donations to other states’ preexisting charitable donation tax credit programs are also done in many instances for tax planning purposes.
Adam Thimmesch, a tax law expert at the University of Nebraska-Lincoln, said one means of distinguishing between preexisting tax credit programs and the new state SALT workarounds could be how narrowly focused the state funds receiving donations are. A “100 percent credit for a donation to a [state] general fund looks the worst” compared with a partial or capped credit going to a discrete fund dedicated to a specific purpose, such as education, Thimmesch said. “But as everyone realizes, the more specific the IRS gets in guidance or regulation, states can respond” by altering their SALT workarounds to look more like the pre-TCJA programs. For example, pending California S.B. 227 was amended in January to reduce the value of the credit to be awarded to California Excellence Fund donors from 100 cents on the dollar to 85 cents, to shield the program from being invalidated for providing too direct a tax benefit to donors.
It would be challenging for the IRS to capture all the differences between states’ SALT cap workarounds in a single rule. For instance, Oregon’s tax credit program (S.B. 1528), enacted in April, doesn’t give taxpayers a guaranteed tax credit in return for donations to the state’s college tuition grant program. The credits are auctioned instead, so donors have only a chance at securing a state tax break in return for their donation.
Although the Oregon program was designed in large part to counter the new SALT cap, in execution “it’s identical to our film tax credit auction, which we’ve had for 10 years,” said Oregon Senate Finance and Revenue Committee Chair Mark Hass (D), who sponsored the legislation. “And the IRS has never taken issue with that.”
“It’s going to be exceedingly difficult for the IRS to draw a reasonable, enforceable line between the newest workarounds and any of the older credits,” according to Davis, who said a recent ITEP report highlights that conundrum. “The core problem here is that taxpayers are getting charitable deductions for gifts that aren’t genuinely charitable.”
But Vesely cautioned that current IRS opinions upholding the use of state tax credits and the federal charitable deduction are “really not precedential” and could be vulnerable in a court battle. That position has been taken by Jared Walczak of the Tax Foundation, who has repeatedly criticized SALT cap workaround proposals as problematic because the contributions would generally be made for financial gain. The IRS notice should give pause to states mulling workarounds, Walczak recently told Tax Analysts.
Thimmesch said the previous IRS memos show “that the IRS has acquiesced to these programs in the past,” noting that there are court holdings that indirectly support some of their conclusions. However, the memos are “informal and nonbinding,” and a key 2011 memo indicated that in some circumstances, a donation receiving a state tax break might be viewed by the agency as merely satisfying a state tax liability, rather than serving as a federally deductible donation, he added.
Bradley Marsh of Greenberg Traurig LLP said most taxpayers’ reluctance to test the IRS position regarding the state SALT workarounds is wise, given the agency’s power. “In making this announcement, the IRS is ‘gently’ reminding everyone that the federal government, not the state or the taxpayer, etc., has say on what a charitable contribution is and isn’t,” he said.
Congress could act legislatively to counter state efforts to circumvent the SALT cap or create a compromise that would mollify the states hurt by the limited deduction. However, states have other strategies to counter the SALT cap — including shifting some of their revenue raising to payroll taxes (an optional version of which was passed as part of New York’s workaround legislation) or establishing federally deductible, entity-level taxes on passthrough businesses while providing a proportionate state tax credit to passthrough owners, a strategy enacted in May in Connecticut.
States “may decide to shift their taxes to corporate [entities], where it is fully deductible,” Norman said, although those schemes could be complex to administer, particularly the payroll tax proposal, which would involve creating a tax credit for employees to counter an anticipated drop in wages.
“These workarounds are going to be of greater or lesser merit depending on how they are drafted,” Marsh said. “My sense of it is that this will be a ‘war zone’ for several years to come. . . . Some of the workarounds will survive, and others won’t.”
A neglected option is for highly progressive states to broaden their tax base and reduce their steep rates on high earners. Vesely said lawmakers and commentators have argued that “states like California are attacking this the wrong way — they need to lower their rates for individual taxpayers.” But “we’re not going to see that,” he said.