IRS signals intent to shut down schemes to avoid state tax deduction limits

Tax Hot Topics newsletterThe IRS announced plans last week (Notice 2018-54) to write regulations addressing state laws that allow taxpayers to make charitable contributions to fulfill their state tax obligations.

The tax legislation passed in December known as the Tax Cuts and Jobs Act limits the individual deduction for state and local taxes to $10,000, and many states are scrambling to pass legislation that would allow their residents to continue receive the value of an unlimited deduction. One of the most popular strategies, already enacted by New York, New Jersey and Connecticut, would allow local governments to set up charitable organizations to fund services, with residents receiving property tax credits for contributions. The aim of these proposals is to allow taxpayers to recharacterize state and local tax payments as fully deductible charitable contributions for federal income tax purposes.

Notice 2018-54 does not offer a definitive conclusion on these laws, but it appears, based on the notice’s language, that the IRS is looking to shut down the strategy. The notice states that “the proposed regulations will make clear that the requirements of the Internal Revenue Code, informed by substance-over-form principles, govern the federal income tax treatment” of transfers to funds controlled by state and local governments.

The reference to “substance over form” could indicate that the IRS would simply treat the contributions as equivalent to normal state tax payments. Many commentators have also suggested that the payments would not be deductible because the regulations and case law generally only allow a deduction for payments in excess of goods or services received in consideration. Both the state tax credits and the government services could likely be viewed as consideration. On the other hand, some commentators have pointed to existing state tax credit scholarship granting organizations that operate in similar ways.

States are also pursuing other strategies. Connecticut also enacted a law that imposes an entity level tax on pass-throughs that reduces the state tax individual owners pay on the income. Several states are also considering mechanisms to facilitate employers paying state tax on behalf of employees.

Contacts Dustin Stamper
Director, Washington National Tax Office
T +1 202 861 4144

Shamik Trivedi
Senior Manager, Washington National Tax Office
T +1 202 521 1511

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