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November 15, 2018 Practice Point

States Work to Avoid Impact of TCJA Limitation on State and Local Tax Deduction and IRS Weighs in on Attempted Workarounds

By Jaye Calhoun, Kean Miller LLP, New Orleans, LA

Since the amendment of Internal Revenue Code section 164(b)(6) to limit joint filing taxpayers’ deduction for state and local taxes to $10,000 annually (pursuant to the 2017 tax legislation, frequently called the Tax Cuts and Jobs Act or TCJA, P.L. 115-97), a number of states have considered or enacted various workaround measures to avoid or mitigate the effect of the new limitation on their residents.  State efforts have taken several forms, including state legislation allowing for “charitable” contributions intended for use by a state or local governmental entity and linked to a corresponding credit against state or local taxes, as well as voluntary and deductible employer payments of what would otherwise have been an employee’s tax obligations, to the more radical idea of imposing an entity-level income tax on otherwise pass-through entities, with a corresponding credit to the owners of the pass-through entity for the tax “paid” by their entity. 

With respect to the former, states have considered legislation allowing for direct “donation” of funds to state or local governmental entities,1 or creating public charities under section 501(c)(3) to which taxpayers could make “voluntary” contributions, which donations or contributions would then be delivered to specified governmental entities and used to fund certain state or local government operations. In exchange, the donor/taxpayer would receive a complete or partial credit against specified state or local taxes and, theoretically, the payment would also be deductible as a charitable contribution under section 170 for federal income tax purposes.  Some commentators have questioned whether a “contribution” made to a state or local government, when creditable against one’s own tax liability, could be considered “voluntary” within the meaning of section 170, and whether any such scheme could be viewed as other than a disguised tax payment, and whether, even if made to a separate charitable organization, if that organization could be viewed as other than an agent of the intended recipient government.2

The Internal Revenue Service doesn’t seem to be buying at least some of these workaround efforts.  On August 23, 2018, the IRS published proposed regulations3 making it clear that, to the extent state or local tax credits are granted in return for a contribution to a section 170(c)-qualified organization, the payor’s federal charitable deduction is reduced dollar for dollar.  The proposed regulations state that the rule applies to contributions to all section 170(c) organizations, not just to entities formed by state or local governments, but the regulations allow for a de minimis exception if the amount of the state tax credit does not exceed 15% of the contribution.

The IRS, in issuing the proposed regulations, attempted to shoot down several of the grounds on which proponents of this type of workaround had relied.  Specifically, Chief Counsel Advice 201105010 was downplayed as not controlling and not precedential.  Further, the state tax credit technique was said to undermine congressional intent in limiting state and local tax deductions.  The regulations, once they are finalized, are currently stated to be retroactively effective to August 28, 2018, suggesting that the IRS will not challenge contributions that were made to pre-existing programs before that date.  A public hearing on the proposed regulations is scheduled for November 5, 2018.  Reportedly, approximately 7,300 comments were filed with the IRS with respect to these proposals. On September 5, 2018, in a news release,4 the IRS offered a “clarification for business taxpayers: payments under state or local tax credit programs may be deductible as business expenses.”  However, panelists at the ABA Tax Section meeting in Atlanta pointed out several ambiguities in this news release.

Of particular concern in light of the proposed regulations is the fate of student tuition or scholarship granting-organizations (STOs), most of which existed long before the TCJA and subsequent state workaround attempts.  California, new to the concept, had proposed legislation (which ultimately did not pass) to allow taxpayers to make voluntary contributions to certain qualifying tuition-paying entities and receive an 85% state tax credit for their contribution.5   Nonetheless, 18 other states have had laws authorizing the formation of private, nonprofit organizations to fund tuition and books for low-income or needy students, many of whom are hoping to leave a failing or under-performing school, or simply to allow for school choice: those states have historically provided a limited state tax credit to donors in exchange for their contributions to these organizations.6   For example, Louisiana law7 allows for such programs that have relied on contributions made by citizens seeking a credit or rebate to provide scholarships to low income students throughout the state.

A number of these organizations have approached the IRS seeking to be excluded from the scope of the final regulations.  Bruce Ely, of Bradley Arant Boult Cummings LLP, in Birmingham, AL, is part of the effort to correct this for historical STOs.  He notes:

The IRS cast far too wide a net here as evidenced by the fact that their warning shot—Notice 2018-54—said nothing about targeting these scholarship-granting organizations that have been around long before there was even a discussion of a SALT cap.  The IRS and certain Treasury officials may view these organizations and the kids they benefit as collateral damage, but I wonder if they’re prepared to help my clients choose which children lose their scholarships if we witness a substantial drop-off in donations as a result of these over-reaching regulations. These STOs relied on numerous items of IRS guidance, and not just one 2011 CCA, when they made these scholarship commitments—and those commitments usually last until the child graduates from high school or his or her family’s income rises above the poverty level.  

It should be noted that the long-standing IRS policy of tolerating state tax credits in situations in which federal charitable contribution deductions were also available might be viewed as having established a precedent allowing states to now create “workarounds” for what would otherwise be a non-deductible state or local tax.  It is not clear why the newly enacted state responses to federal tax changes are any less reasonable than the comparable state programs that have existed for some time.

Not addressed in the proposed regulations (which were, of course, issued under the Code provision providing for charitable deductions), however, is the other main approach taken by, or under consideration, in heavily impacted states.  For example, the State of New York took a different path looking to provide some relief to its citizens.  New York passed legislation allowing for the transfer of non-deductible personal income tax paid by employees in the state to a deductible payroll tax paid by employers.8 In that case, if an employer opts in to an optional payroll tax regime by December 1 of the preceding year, the employer will pay a voluntary tax on wages paid to the extent such wages exceed $40,000 per employee (1.5% in 2019, 3% in 2020, 5% in 2021 and thereafter) and may decrease the employee’s compensation to take this additional tax payment into account. In turn, the employee receives a corresponding credit against personal income tax, which credit is expressly not linked to payment of tax by the employer. Since payroll taxes are withheld from wages paid by the employer and deductible as wages paid by the employer, this alternative mechanism of payment of the tax to the state directly by the employer ensures that the state receives the same amount of tax, the employer receives the same amount of deduction and the employee pays less in tax overall (to offset the loss of the employee’s federal tax deduction). 

Whether or not the IRS is comfortable with this scheme, there are many potential issues for employers who would incur increased administrative cost, and for employees, particularly non-New York employees who may pay tax in other states on the same income for which they will no longer get a credit for taxes paid to New York.

Connecticut, in turn, enacted legislation attempting to shift the liability of individuals for the payment of SALT to an entity-level liability, enacting a pass-through entity tax9 and corresponding credit for pass-through owners.  For taxable years beginning after December 31, 2017, pass-through entities doing business in the state of Connecticut will be subject to an entity level income tax of 6.99%. In turn, partners, members, and shareholders of the pass-through entities will be entitled to a Connecticut tax credit equal to 93.01% of their direct or indirect share of the pass-through entity’s state tax liability.

New Jersey has enacted a law that allows its state residents to declare property taxes as charitable donations.10 This will allow the property owners to “donate” up to 90% of their tax bill to charitable funds set up by municipalities in exchange for tax credits.

Not simply content to rely on state legislation to address these issues, in July, the states of New York, New Jersey, Connecticut, and Maryland filed suit against the IRS and the Department of Treasury challenging the constitutionality of the deduction limitation.  Stay tuned for further developments!

1 A voluntary contribution to a state or local government or a political subdivision can be deductible as a charitable contribution under section 170(c)(1) if made for a public purpose.

2 Peter Faber, Do Charitable Contributions Avoid the TCJA SALT Deduction Limit?, State Tax Notes (Apr. 23, 2018).

3 Treas. Reg. §1.170A-1(h)(3).

4 IR-2018-178.

5 See SB-227 Education Finance: Local Schools and Colleges Voluntary Contribution Fund: personal income taxes: credits; & SB-581 State Contributions: California Excellence Fund.

6 Alabama, Arizona, Florida, Georgia, Louisiana, Illinois, Montana, Nevada and South Carolina are among the states offering this kind of tax credit for contributions.

7 Louisiana Scholarship Program/Tuition Donation Program, see La. R.S. 43:6301 (B)(C)(ix).

8 Article 24, New York Tax Law, Employer Compensation Expense Program.

9 CT Public Act 18-49.

10 NJ S1893.