Proponents of federal tax reform hoped that changes to 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. code would spark innovation. If legislative innovation counts, the new law is already an unqualified success, with legislators several high-tax states devising measures intended to preserve the full state and local tax deduction for high-income residents, which is now capped at $10,000.
In California, Senate Bill 227 creates the California Excellence Fund and provides a credit against state income tax liability for contributions in the fund, effectively recharacterizing state tax liability as charitable contributions which can be deducted on taxpayers’ federal income tax returns. The bill has cleared two Senate committees, and is pending a floor vote. Similar legislation has been introduced in Illinois, Nebraska, Virginia, and even Washington, which doesn’t have an income tax (that bill would offer a sales tax exemption certificate).
These proposals, while creative, faces serious legal headwinds. For a detailed analysis of the legal hurdles faced by contribution in lieu of taxes schemes, click here. But if you’re looking for the abridged version, here’s what you really need to know:
- Charitable contributions to government are only deductible, per IRS guidance, if the contribution “is solely for public purposes (for example, a gift to reduce the public debt or maintain a public park).” By contrast, these contributions primarily serve a private purpose (reducing federal tax liability through recharacterization), as they do not yield any increased revenue for the state.
- When claiming the charitable deduction, the taxpayer must exclude contributions from which one benefits. For instance, if one purchases a $250 ticket to a benefit dinner, and the fair market value of the dinner is $50, then $200 can be deducted—not $250. In this instance, the taxpayer receives a benefit equal to the entire value of the contribution in lieu of taxes (the corresponding 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. ), wiping out any deductible share.
- Case law and IRS regulations generally require charitable intent for a contribution to be deductible, meaning that the individual does not receive a substantial benefit from the contribution. The sole purpose of the proposed contributions in lieu of taxes proposal is financial gain. (the U.S. v. American Bar Endowment, Hernandez v. Commissioner, Singer Co. v. U.S.)
- The IRS has broad authority to classify a payment or charge as a tax based upon its real nature. If it looks like a tax and acts like a tax, the IRS and the courts could simply say that it is a tax.
Proponents of these bills have countered by noting that many states offer generous credits for contributions to neighborhood assistance programs (e.g., free clinics, food pantries, shelters) and scholarship organizations, and that these contributions remain deductible at the federal level despite extremely high credit percentages at the state level. The IRS has never issued formal guidance on the matter, but proponents lean heavily on a non-precedential internal memo provisionally allowing the deduction in these instances, subject to future guidance. However, there are good reasons to think that this won’t leave contributions in lieu of taxes in the clear:
- In all cases, taxpayers had the option to give to private nonprofits (frequently this is the only option). The memo highlighted the private charitable aspect in green-lighting the deduction.
- The memo notes that “[a] transfer is not made with charitable intent if the transferor expects a direct or indirect return benefit commensurate with the amount of the transfer,” yet this is the advertised intent of SB 227.
- The memo stipulates that “there 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.” Contributions in lieu of taxes are precisely such a circumstance.
These proposals are proliferating, but senior Treasury Department officials have been dismissive thus far, with Secretary Steve Mnuchin terming such efforts “ridiculous.” Whatever their political advantages, the IRS will see right through contributions in lieu of taxes schemes and treat the payments as what they really are: tax payments by another name.
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