States Sue U.S. to Void $10,000 Cap on State and Local Tax Deduction

Article Highlights:

• Four States Sue Federal Government 
• High-Tax States 
• Challenging the $10,000 Itemized Deduction for State and Local Taxes 
• Charitable Deduction Work-Around 
• Substance over Form 
• Proposed IRS Regulations to Counter Work-Arounds 
• Taxpayers Should Exercise Caution 

Four states – New York, Connecticut, Maryland and New Jersey – have sued the federal government to void the tax-reform cap on the federal itemized deduction for state and local taxes, contending that limiting the deduction is unconstitutional. The taxes at issue include state and local income taxes, real property (real estate) taxes and personal property taxes.

These states – all Democratic (blue states), with some of the highest state and local tax rates in the nation – saw this deduction limitation as political retribution from the Republican-controlled Congress and have passed state legislation attempting to circumvent the tax reform provision limiting the federal itemized deduction for state and local taxes (SALT) to $10,000.

Both NY and NJ have created charitable funds that their state constituents can contribute to and allows them to receive a credit against their state and local taxes. NY’s legislation allows 85% of the amount contributed to the fund as a credit against taxes, while NJ allows 90%. The Connecticut law allows municipalities to create charitable organizations that taxpayers can contribute to in support of town services, from which they then receive a corresponding credit on their local property taxes. Each of these measures essentially circumvents the $10,000 limitation on SALT deductions.

However, two big questions are whether a donation for which a donor receives personal benefit is really a deductible charitable contribution and whether the state legislatures really thought this through. These work-arounds overlook one of the long-standing definitions of a deductible charitable contribution: the donor cannot receive any personal benefit from the donation.

Recently, the IRS waded into the issue with Notice 2018-54 and an accompanying news release, informing taxpayers that it intends to propose regulations addressing the federal income tax treatment of certain payments made by taxpayers to state-established "charitable funds," for which the contributors receive a credit against their state and local taxes – essentially, the work-arounds adopted or proposed by the states noted above and others. In general, the IRS indicated that the characterization of these payments would be determined under the Code, informed by substance-over-form principles and not the label assigned by the state.

The proposed regulations will:

1. "Make clear" that the requirements of the Code, informed by substance-over-form principles (see below), govern the federal income tax treatment of such transfers; and 
2. Assist taxpayers in "understanding the relationship between the federal charitable contribution deduction and the new statutory limitation" on the SALT deduction. 

Substance over form is a judicial doctrine in which a court looks to the objective economic realities of a transaction, rather than to the particular form the parties employed. In essence, the formalisms of a transaction are disregarded, and the substance is examined to determine its true nature.

The implication of the IRS's reference to the substance-over-form doctrine is likely that the formal mechanisms for implementing the state work-arounds – e.g., charitable contributions to "charitable gifts trust funds" – will not dictate their tax treatment. That is to say, the IRS will not recognize a charitable contribution deduction that is a disguised SALT deduction.

While the notice only mentions work-arounds involving transfers to state-controlled funds, another type of work-around has been enacted, and others have been proposed. In addition to the "charitable gifts trust funds" described above, New York also created a new "employer compensation expense tax" that essentially converts employee income taxes into employer payroll taxes. The IRS stated in Information Release 2018-122 that it is "continuing to monitor other legislative proposals" to "ensure that federal law controls the characterization of deductions for federal income tax filings."

Allowing these work-arounds to stand would open Pandora’s Box to other schemes to circumvent the charitable contribution rules. For example, a church could take donations and then give the parishioner credit for the parishioner’s children’s tuition at the church’s school – something that is not currently allowed.

Have these states set their citizens up for IRS troubles if they utilize these work-arounds? Are these states now concerned that their work-arounds might not pass muster and will be ruled invalid after several years in the courts, so they are now pre-emptively suing the federal government?

Taxpayers in states with work-arounds should carefully consider all potential ramifications when deciding whether to get involved with something that could drag through the courts for years, with potential interest and penalties on taxes owed if (more likely, when) the IRS prevails.

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