IRS to issue guidance on state efforts to circumvent tax-law provision

The Treasury Department and IRS announced Wednesday that they will issue guidance relating to blue states’ efforts to circumvent limits on state and local tax deductions under the GOP-backed tax law.

A notice issued by the agencies signaling their intent to propose regulations comes as tax experts and politicians debate whether the IRS would bless the workarounds states are putting forward.

Under the new law, the state and local tax (SALT) deduction is capped at $10,000. The new limit on the deduction has been a concern for elected officials in high-tax states such as New York, New Jersey and Connecticut, who worry that it will lead to an increase in their residents’ federal income taxes.

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Politicians in blue states have proposed or enacted measures to provide workarounds to the cap on the SALT deduction. Some of these measures allow residents to make donations to state and local funds in exchange for credits against their state and local taxes. The intention is for the donations to also be deductible as charitable contributions on their federal income taxes, since the charitable deduction wasn’t capped in the new tax law.

Blue-state politicians have noted that many states already have arrangements in which taxpayers get a credit against their state taxes for donations to private education, and the donations have been tax deductible. But some tax experts have questioned whether the IRS would give a green light to the SALT cap workarounds, arguing that the agency might not see the donations to state and local funds as truly charitable in nature.

Treasury and the IRS said in their notice 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 such transfers.”

The agencies also said that “taxpayers should be mindful that federal law controls the proper characterization of payments for federal income tax purposes.”

Jared Walczak, senior policy analyst with the Tax Foundation, said that the emphasis in the notice on the “substance-over-form” doctrine suggests that Treasury and the IRS will treat the donations as tax obligations that are not deductible, even if states call them charitable contributions.

“It doesn’t matter what label you apply, if you are satisfying a tax obligation, the IRS will treat it as such,” he said.

Frank Sammartino, a senior fellow at the Urban-Brookings Tax Policy Center, said that it’s unclear how the guidance will treat the SALT cap workarounds, but that Treasury officials have “expressed some skepticism in the past” about the arrangements.

Treasury and the IRS are “putting people on notice,” he said. 

A handful of House Republicans from New York, New Jersey and California voted against the tax bill signed by President Trump because of the SALT cap. But most other Republicans voted for the bill, arguing that the federal government shouldn’t be subsidizing state taxes.

House Ways and Means Committee Chairman Kevin Brady (R-Texas) applauded the notice from Treasury and the IRS on Wednesday.

“There are many mayors and governors who do a good job of balancing budgets and creating jobs in their communities without high taxes, and I encourage those few states that are trying to undermine our growing economy to instead focus on how they can lower their own taxes on their constituents and keep moving our economy forward,” he said.