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 Che Odom
New York and New Jersey taxpayers should brace for federal challenges if they take advantage of new state approaches to mitigate the impact of the limit on deductibility of state and local taxes.
Tax lawyers told Bloomberg Tax that new state workarounds of the new $10,000 cap on the federal deduction are vulnerable to Internal Revenue Service challenges at best and are half-baked at worst.
“Clearly, it is understandable why the states are moving down this path, but they should be aware that the risk of federal challenge is significant,” Jamie Yesnowitz, a principal and state and local tax practice and national tax office leader at Grant Thornton LLP, said.
New Jersey Gov. Phil Murphy (D) signed a bill ( S. 1893) May 4 that permits municipalities, counties, and school districts to establish charitable funds and allow donors to receive property tax credits in exchange for donations.
State Attorney General Gurbir Grewal is prepared to defend the legislation, according to one of the bill’s sponsors, Assemblyman John McKeon (D).
New Jersey follows neighboring New York, where Gov. Andrew Cuomo (D) on April 12 gave his approval to state-operated charitable funds that entitle taxpayers to claim a state tax credit of 85 percent of the donation to health care and education funds. The credit appeared in a larger omnibus budget bill ( S. 7509).
That bill included a voluntary payroll tax on employers, which is another means by which New York attempted to provide relief to wage earners impacted by the new $10,000 limit on the deductibility of taxes paid to state and local governments on federal tax returns.
The charitable contribution approach “raises the specter of a federal challenge, given that it appears to encourage New York taxpayers to make these gifts simply as a means to recharacterize tax payments that would otherwise be capped” under the 2017 federal tax act ( Pub. L. No. 115-97), Yesnowitz said.
Other states considering the use of charitable funds are “likely to face the same issues that New York may face,” Yesnowitz said.
Lawmakers in Illinois and California are considering similar bills. The Illinois bill ( H.B. 4237) would permit taxpayers to contribute state and local taxes owed above the $10,000 cap to a state charity, the Illinois Excellence Fund, to receive the credit. The House approved it April 18, but it has hit a snag in the Senate.
Chief sponsor Sen. Julie Morrison (D) said during a May 2 legislative hearing that the bill lacks specific language requiring counties collecting taxpayer funds designated as charitable contributions to fairly distribute the funds to school districts and other units of government.
Two California bills ( A.B. 2217 and S.B. 227) also provide ways to mitigate the federal deduction cap. One offers a credit for contributions to a state “Excellence Fund,” and the other allows state nonprofit organizations, school districts, and institutes of higher learning to sell credits to interested taxpayers.
Under these charity-fund approaches, the state benefits minimally, if at all, “while the whole purpose is to advantage the donor, flipping the meaning of charity on its head,” Jared Walczak, a senior policy analyst at the Tax Foundation, told Bloomberg Tax.
“The IRS will see right through these schemes, and states which promote them risk leaving their taxpayers on the hook,” he said.
The Connecticut Senate passed a bill ( S.B. 414) May 2 that would create a 200 percent income tax deduction for contributions to a “citizens in need account” to benefit residents who have had their benefits from state social services programs reduced because of state budgetary constraints. The House is considering the measure.
“I am abundantly confident, totally confident that based on IRS rulings, based on IRS practice, and based on the legislation that’s been tolerated and accepted for a very long time in red states all over the country that the charitable-contribution approach is defensible and appropriate,” Kevin B. Sullivan, Connecticut Department of Revenue Services commissioner, said May 3 at a conference held by Ernst & Young LLP in New York.
That’s wishful thinking, according to Steven Wlodychak, a principal with EY’s indirect tax practice. Any taxpayer who claims these charitable deductions in lieu of tax can expect an IRS challenge, he told Bloomberg Tax.
IRS and Treasury Department officials, including Secretary Steven Mnuchin, have said as much, he said.
“My question to the state political leaders who may enact these charities laws is whether they will fully compensate all of the accounting and legal expenses of the taxpayers who will be challenged by the IRS,” Wlodychak said.
The trouble comes with how a taxpayer qualified for a charitable deduction for contributions “for which they get an offsetting monetary benefit"—a credit against their state taxes—"and to support public services that are likewise supported by nondeductible taxes paid by others, Wlodychak said.
“I think they will be challenged, and I doubt that federal judges will sympathize with the states—and taxpayers—when there is clear congressional language and intent to limit these deductions,” he said.
IRS Publication 526 says that taxpayers can’t deduct as a charitable contribution any payment for which they receive a benefit in return.
To contact the reporter on this story: Che Odom in Washington at firstname.lastname@example.org
To contact the editor responsible for this story: Ryan C. Tuck at email@example.com
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