The Internal Revenue Service (IRS)The Internal Revenue Service (IRS) is part of the U.S. Department of the Treasury and is responsible for enforcing and administering federal tax laws, processing tax returns, performing audits, and offering assistance for American taxpayers. is expected to issue formal guidance on the legality of SALT deduction cap workarounds any day now, and the taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. community is on pins and needles. What will the guidance say? Will it spare existing credits? While we wait on the IRS, let’s consider a few questions about what’s to come.
What is the SALT deduction cap anyway, and why does it matter?
Prior to the enactment of the Tax Cuts and Jobs Act, taxpayers who itemize were permitted to deduct the entire value of their major state and local tax payments from federal income, reducing their federal income tax liability. This policy substantially reduced tax liability for many high-income filers, particularly those in high-tax states. Under the new law, the state and local tax (SALT) deductionThe state and local tax (SALT) deduction permits taxpayers who itemize when filing federal taxes to deduct certain taxes paid to state and local governments. The Tax Cuts and Jobs Act (TCJA) capped it at ,000 per year, consisting of property taxes plus state income or sales taxes, but not both. is capped at $10,000.
While most filers are still better off due to lower rates and other reforms, some states appreciated the degree to which the uncapped deduction lowered the effective cost of their own taxes, and have sought to develop workarounds to retain the old benefit—plus, of course, the lower rates its reduction was supposed to help pay for. The most common strategy has been to establish government-linked “charitable” funds, allowing taxpayers to make a voluntary contribution to the state charity (theoretically eligible for the charitable deduction) and receive an offsetting tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. , reducing state tax liability.
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But the IRS isn’t going to go along with that, is it?
No, probably not. We’re still waiting on formal guidance, but the IRS has already (intentionally) tipped its hand in the notice it issued about forthcoming guidance, noting that it would be based on the well-established principle of “substance over form.” The idea here is that the IRS doesn’t care about nomenclature: you can call it a tax payment, a charitable contribution, or any name you can think up, but if it’s a payment made in satisfaction of your tax liability, then it’s a tax payment.
The IRS will be on solid footing with such a determination. Existing law, case law, regulations, and guidance all point in this direction, and the IRS has broad latitude to establish rules governing what constitutes a charitable contribution. We’ve spelled out the legal arguments previously; if you’re interested, you can learn more here.
So why the suspense?
While a few are hoping for a different outcome, most observers expect the IRS to disallow these new, intentional SALT workarounds that have been adopted by New York and a handful of other states. There is, however, a broader impact, one that affects most if not all states. Taxpayers across the country have access to a range of state tax credits designed to promote charitable giving, some more generous than others. Broadly speaking, these can be split into two buckets: neighborhood assistance credits, which provide substantial tax relief for individuals and businesses who give to social welfare causes (free clinics, food pantries, mental health services, etc.), and scholarship tax credits, for taxpayers who help endow school choice scholarships. The latter tends to be more prominent in red states; the former can be found just about everywhere.
These programs were not designed as SALT deduction cap workarounds–they were created before the cap–but the most generous ones can function in the same way now, with a contribution actually yielding a financial benefit to the donor. The IRS has permitted taxpayers to take a federal deduction for such incentivized contributions in the past, when it only made a difference in overall liability for alternative minimum tax (AMT)The Alternative Minimum Tax (AMT) is a separate tax system that requires some taxpayers to calculate their tax liability twice—first, under ordinary income tax rules, then under the AMT—and pay whichever amount is highest. The AMT has fewer preferences and different exemptions and rates than the ordinary system. filers, but the forthcoming guidance could implicate these programs as well.
Can these charitable preferences be distinguished from intentional SALT deduction cap workarounds?
Possibly. There are several distinguishing factors. Existing limitations on claiming the SALT deduction try to get at the notion of donative intent—the idea that you’re making a contribution for some reason other than your own benefit. They do this, primarily, in two ways: first, by requiring you to reduce the amount you deduct by any benefit you receive because of the contribution, and second, by requiring a similar reduction for any liability your contribution imposes on the recipient.
If the recipient is the government, or a government-linked entity, and it’s obliged to provide you an offsetting tax credit, that’s a liability that should reduce (or, in the case of a 100 percent credit, wipe out) the amount you can claim for purposes of the federal tax deductionA tax deduction is a provision that reduces taxable income. A standard deduction is a single deduction at a fixed amount. Itemized deductions are popular among higher-income taxpayers who often have significant deductible expenses, such as state/local taxes paid, mortgage interest, and charitable contributions. . Or you can get there the other way: the credit you receive is a benefit that should reduce how much you can claim. But what if the recipient is a true third party? They aren’t giving you something for making the contribution. Does the government’s incentive/reward for your contribution constitute a benefit of making the contribution, given that the benefit isn’t conferred by the recipient? (Especially since this comes at a substantial cost to the government, which is forgoing–not merely recharacterizing–revenue.) That’s what the IRS will have to determine. It’s not clear-cut.
Some have also raised the possibility that the IRS will simply grandfather in any credits that existed prior to the enactment of the new federal tax law, but given that the new law changes how those credits work, such an approach would represent dubious policy.
What will happen to these existing credits if the IRS doesn’t distinguish them from intentional SALT workarounds?
Not much. They’re still going to be incredibly attractive to potential donors. Imagine, for instance, a 75 percent credit for your $10,000 contribution to a free clinic. The IRS could do one of three things: it could allow you to deduct the full $10,000, even though you’re getting a state tax credit worth 75 percent of the contribution; it could allow you to deduct the $2,500 residual contribution above and beyond the value of the credit; or it could disallow the deduction in its entirety due to the credit. (If the IRS took the latter route, guidance might have to establish a threshold at which benefits disallow a claim.)
Let’s assume that you’re in the top tax bracketA tax bracket is the range of incomes taxed at given rates, which typically differ depending on filing status. In a progressive individual or corporate income tax system, rates rise as income increases. There are seven federal individual income tax brackets; the federal corporate income tax system is flat. and have already maxed out your state and local tax deduction. In the first scenario, your $10,000 contribution saves you $11,200 in taxes (a $7,500 state credit and a deduction worth $3,700 in federal tax savings at the 37 percent top marginal rate). You’ve actually made money on your contribution. In the second scenario, you get the $7,500 in state tax savings and deduct $2,500 (worth $925 in federal tax reductions), getting a tax savings of $8,425 on a contribution of $10,000. Finally, if the entire contribution is disallowed for purposes of the federal deduction, you get $7,500 back in tax savings for your $10,000 charitable contribution.
In any scenario, that’s an incredibly good deal for a charitable gift. And some of these programs–particularly the scholarship tax credit programs–have credits set at or near 100 percent of the value of the contribution. Even if the IRS disallows the federal deduction, these programs would continue to be extremely attractive to charitably-inclined taxpayers. In fact, for anyone who wasn’t previously subject to the alternative minimum tax, nothing at all would change from last year.
The same can’t be said for intentional workarounds, of course, because they fail if the credited amount isn’t deductible. Their sole purpose, from the taxpayer’s perspective, is to reduce overall tax liability, and if they can’t do that, no one would take advantage of them.
Is one outcome more likely than another?
It’s likely between two possibilities: (1) prohibiting recharacterization (intentional workarounds) but distinguishing incentivized contributions to genuine third-party recipients, or (2) reducing the value of any contribution by the benefit received (regardless of source). There’s little doubt, however, that the tax avoidance strategies a few states are pursuing will be ruled out.Share