Tax Reform Friday: Fight Over Charitable Deduction for Donations in Lieu of State Tax Payments Is Just Beginning



The impact of Pub. L. No. 115-97's $10,000 cap on the so-called “SALT” deduction on an individual taxpayer is dependent on a number of factors, but those taxpayers in states that generally impose tax at a higher rate will take the brunt of this blow. In response, many states are attempting to devise ways to reduce their citizens’ tax burdens without necessarily depleting their own revenue. One plan that seems to be gaining in popularity is allowing taxpayers to make charitable donations in lieu of tax payments. States would set up nonprofit organizations to fund big-ticket items like education, and individuals would be allowed a state income or property tax credit equal to the amount donated. Bills proposing variations of this idea have been submitted in California, Maryland, New Jersey, and New York, among others.

However, the issue is not that simple to resolve. Many tax professionals and federal officials are pushing back against the legality of this scheme. The primary rationale against allowing these plans is found in IRS Publication 526, which states that taxpayers may not take a deduction for amounts for which they receive a benefit in return. The simplest example of this is a taxpayer who makes a $100 donation to a nonprofit organization and receives a gift worth $50 in return. In this instance, the federal deduction for this donation is limited to $50, or the amount of the donation minus the value of items received. Those doubting the legality of the states’ plans say that the state tax credit received in return for the donation is a “benefit” that must be subtracted from the amount deducted.

A group of law professors has written a paper in opposition to this point of view. These professors make numerous arguments in support of their position, including the claim that if the value of a nonrefundable state tax credit must be subtracted from the amount deducted, other tax benefits must also be subtracted. Thus, if taking a deduction for a $100 charitable contribution conferred $20 of tax benefits, a taxpayer would only be allowed to deduct $80. As this has never been the case, they argue, a reduction in taxes cannot be a “benefit” for purposes of IRS Publication 526.

Regardless of which side you find most persuasive, Treasury Secretary Steven Mnuchin has made it clear that the IRS intends to fight any state’s effort to offset the cap on the SALT deduction through charitable contributions, promising audits in states attempting this move. It doesn’t appear that either side is willing to back down at this point, as states continue to consider legislative and regulatory responses to the federal tax reform law, meaning that it could be years before the issue is settled in the courts.

Continue the discussion on Bloomberg BNA’s State Tax Group on LinkedIn: Do state tax credits constitute a “benefit” to taxpayers?

For more information on the impact of Pub. L. No. 115-97, examine Bloomberg Tax’s Tax Reform Roadmap, showing detailed comparisons between pre-reform law and impending changes, with pertinent cites attached.

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