California End-Run Around Tax Deduction Cap Passes First Test

Daily Tax Report: State provides authoritative coverage of state and local tax developments across the 50 U.S. states and the District of Columbia, tracking legislative and regulatory updates,...

By Laura Mahoney

A bill to let California taxpayers make charitable contributions to the state as an end-run around the new cap on federal deductions for state and local tax payments passed its first legislative test Jan. 10.

California Senate President Pro Tempore Kevin De Leon (D) said his bill ( S.B. 227) is creating pressure on Congress to repeal the new $10,000 cap on federal deductions for taxes paid at the state and local level. It passed on a partisan 5-1 vote in the Senate Governance and Finance Committee, with Democrats favoring and one Republican opposing.

“This new tax law deliberately targets taxpayers in blue states,” De Leon said. “It is designed to shield millions of Californians from significant tax increases.”

The new federal tax law ( Pub. L. No. 115-97), signed by President Donald Trump in December 2017, allows taxpayers to deduct up to $10,000 of property taxes, and state and local income or sales taxes. The previous law placed no limit on the amount of state and local taxes that could be deducted—and many high-tax states are exploring options to combat the slashed tax break.

As it is now written, De Leon’s bill would allow state taxpayers to receive a 100 percent credit for amounts they donate to the California Excellence Fund to satisfy their state income tax liabilities. Taxpayers could claim the credit as a charitable contribution to reduce their federal tax liabilities.

3 Million Californians

De Leon said at least 3 million Californians who pay more than $10,000 combined in state income tax and property tax would benefit from the measure.

The bill moves next to the Senate Appropriations Committee, where amendments may fill out the details. Possible amendments could reduce the credit from the 100 percent proposed and make at least some of the contributions voluntary.

Gov. Jerry Brown (D) said he is willing to consider the idea.

“Yes, I’m certainly open to it,” he told reporters at a news conference to release his proposed budget for the next fiscal year. “It looks interesting. I have two questions: Does it work, and if it does work, will the Internal Revenue Service issue a regulation and completely subvert it?”

The bill must pass the Senate by Jan. 31 to move to the Assembly, where it must pass by Aug. 31 to reach the governor’s desk.

Help for Wealthy?

De Leon tried to beat back criticism from two Republicans on the committee that the bill would mainly help wealthy people, could harm overall charitable giving, lacks detail, and could be undone by the IRS or Congress.

“It’s rich that you guys are trying to help the wealthy now in California, so welcome aboard,” Sen. John Moorlach (R) said.

Sen. Janet Nguyen (R), the committee vice chair, asked De Leon to add provisions to hold taxpayers harmless from penalties if the state enacts the bill and the IRS disallows federal deductions for the state credit.

De Leon said the Republicans were erroneously claiming the bill would mainly benefit the wealthy—and said the bill will withstand scrutiny.

“I want to be sure we don’t mischaracterize this measure as protecting the 1 percent,” he said. “Let’s not go to Armageddon.”

Possible Amendments

Two legal scholars who helped De Leon present the bill to the committee offered ideas for amendments that they said would better protect the bill from administrative or legal challenges.

Darien Shanske, professor from University of California, Davis School of Law, and Joseph Bankman, a law and business professor from Stanford University, said reducing the credit below 100 percent would make it more like similar but smaller-scale tax credit programs in California and more than 30 other states. Making some of the contribution voluntary, rather than a mandatory contribution to satisfy tax liability, would help overcome questions about the benefit a taxpayer receives from the contributions.

“The amendments would make it extremely unlikely it would face a realistic administrative or judicial challenge, and, even if it did, I can’t imagine a taxpayer would be penalized,” Bankman said.

Most Generous

An analysis of the bill from committee staff points out some of the weaknesses that amendments could address.

“This bill would enact the most generous tax credits ever allowed in California, which when combined with the federal charitable deduction, would afford the donating taxpayer benefits that exceed the amount contributed,” the staff analysis said.

Jim Gross, a lobbyist representing the California Society of CPAs, told the committee the group doesn’t have a position on the bill but has concerns. The idea to make at least some of the contributions voluntary would address some of those concerns, he said.

No other witnesses testified for or against the bill. In the brief hearing, lawmakers barely touched on the mechanics or finer points of the proposal, although Moorlach, a CPA, questioned how taxpayers should handle withholding of taxes from their wages, and whether they could simply tell their employer not to withhold at all.

Bankman said taxpayers can already adjust their withholding, and other options can be explored.

To contact the reporter on this story: Laura Mahoney in Sacramento, Calif., at lmahoney@bloomberglaw.com

To contact the editor responsible for this story: Ryan C. Tuck at rtuck@bloombergtax.com

For More Information

Text of S.B. 227 is at http://src.bna.com/vpN.

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