May 29, 2018 IRS to issue proposed regulations that could affect state attempts to circumvent $10,000 limit on federal deduction for state and local taxes The IRS recently announced (Notice 2018-54) that it will issue proposed regulations addressing deductibility of state and local tax payments for federal income tax purposes and informing taxpayers that federal law controls the characterization of the payments for federal income tax purposes regardless of the characterization of the payments under state law. The pending regulations were apparently spurred by efforts in some states to enact an assortment of state legislative changes directly intended to work around the new federal $10,000 deduction limit for state and local tax liabilities added to the federal income tax law under the Tax Cuts and Jobs Act (P.L. 115-97) in December 2017. An IRS news release, issued concurrently with Notice 2018-54, notes that some state legislatures have adopted or are considering legislative proposals allowing taxpayers to make payments to specified entities in exchange for a tax credit against state and local taxes owed; these payments are intended to qualify as "charitable contributions" to which the state and local tax deduction limitation would not apply. Various workarounds have been proposed or enacted in a number of jurisdictions, including California, Connecticut, Illinois, New Jersey and New York. Notice 2018-54 states that the proposed regulations will: (1) "make clear that the requirements of the Internal Revenue Code, informed by substance-over-form principles, govern the federal 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 deduction for state and local tax payments." Implications This two-page IRS notice is interesting for several reasons. First, taxpayers should separate the politics from the taxes — even though co-mingling those topics is the reason for the federal and state approaches. Following the release of the notice, New York Governor Andrew Cuomo stated, in relevant part, that "[w]e have been and will continue to fight against this economic missile with every fiber of our being. The IRS should not be used as a political weapon, and I urge this administration to stop its partisan assault on New Yorkers and instead work with us to deliver real, lasting relief for hardworking families." On the federal level, earlier this year, Treasury Secretary Steven Mnuchin reportedly called these state legislative initiatives "ridiculous." Following the release of Notice 2018-54, House Ways and Means Committee Chair Kevin Brady (R-TX) issued a statement characterizing the various workarounds as "gimmicks" favored by leaders in high-tax states. The notice states that workarounds have been proposed or enacted in a number of jurisdictions, but omits the fact that state governments have had similar initiatives in place for decades. Second, the IRS needs to walk a fine line in this guidance. What the notice does not mention is that the IRS has accepted that a state or local tax benefit is treated for federal tax purposes as a reduction or potential reduction in tax liability. As such, it is reflected in a reduced deduction for the payment of state or local tax under Section 164, not as consideration that might constitute a quid pro quo, for purposes of Section 170, or an amount realized includible in income, for purposes of Section 61 and 1001.1 The tax benefit of a federal or state charitable contribution deduction is not regarded as a return benefit that negates charitable intent, reducing or eliminating the deduction itself.2 When the contribution is in the form of property, the value of the deduction has not been treated as an item of income under Section 61, in the form of an amount realized on the transfer under Section 1001.3 Chief Counsel Advice 201105010 acknowledged the historical background of these arrangements, but goes on to state that "[t]here may be unusual circumstances in which it would be appropriate to recharacterize a payment of cash or property that was, in form, a charitable contribution as, in substance, a satisfaction of tax liability." Apparently, the proposed or enacted legislation in California, Connecticut, Illinois, New Jersey and New York post-2017 are "unusual circumstances." On the other hand, the states with established charitable contribution-linked state tax benefits such as those offered by Virginia and Georgia would not be "unusual"? One can only conclude that "unusual" must be in the eye of the beholder, even though they may have similar economic outcomes to both the government and the taxpayer. Third, the notice issued to the public appears to lack basic elements needed to substantially describe the expected contents of the regulation. It lacks, for example, a description of when the regulation will be effective. One has to ask whether it be retroactive to May 23, 2018 (when Notice 2018-54 was issued) or retroactive to January 1, 2018 (the effective date of the state and local tax deduction limitation)? Little insight is offered as to what constitutes recipient "funds controlled by state and local governments (or other state-specified transferees)." Chief Counsel Advice 201105010 explicitly classified contributions to a "state agency" as a charitable contribution. In the end, the federal government and these implicated state governments appear to politically disagree, with the economics of individual taxpayers caught in the crosshairs of this dispute. For the time being, it is probably advisable for all affected taxpayers to stay out of the crossfire, sit on the sidelines and wait for further clarity on the situation. Regardless of whether the federal or state governments' side of the argument is more compelling, taxpayers should weigh the merits of the IRS's position and historical case law, and whether their particular state has created a legal defense fund for taxpayers to subsidize the cost of challenging the IRS's position, before deciding to wade into the morass. (None of these states has announced any such protective measures or indemnity for any taxpayer seeking shelter under their purported workaround proposals.) ———————————————
——————————————— 1 See, e.g., Revenue Ruling 79-315, 1979-2 C.B. 27, Holding (3) (the amount of a state tax rebate credited against tax is neither included in income nor allowable as a deduction under Section 164); Snyder v. Commissioner, 894 F.2d 1337 (6th Cir. 1990). 2 See McLennan v. United States, 23 Cl. Ct. 99 (1991), subsequent proceedings, 24 Cl. Ct. 102, 106 n.8 (1991), aff'd, 994 F.2d 839 (Fed. Cir. 1993); Skripak v. Commissioner, 84 T.C. 285, 319 (1985); Allen v. Commissioner, 92 T.C. 1, 7 (1989), aff'd, 925 F.2d 348 (9th Cir.1991). 3 Browning v. Commissioner, 109 T.C. 303 (1997) (value of state and federal tax benefits not part of the amount realized from a bargain sale of donated property). | |||||||||||||||||||
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