Can States Game the Republican Tax Bill with the Charitable Contribution Strategy?

by Andy Grewal — Wednesday, Jan. 3, 2018

As part of the new tax bill, Congress imposed limits on the Section 164 deduction for state and local taxes paid or accrued. Under prior law, taxpayers could generally deduct those taxes without limitation, even when those taxes were personal in nature (that is, when those taxes were not connected to business or investment activities). However, the new legislation limits the deduction for personal state & local taxes to $10,000. See new § 164(b)(6).

Taxpayers with high incomes or valuable homes, or who live in high tax jurisdictions, can easily run into the $10,000 limitation. But states have recently considered various strategies under which they could “game the system” and preserve large deductions for their residents. See Ben Casselman, The New York Times, Democrats in High-Tax States Plot to Blunt Impact of New Tax Law, Jan. 2, 2018 (“Mr. de León [president pro tem of the California Senate] and other legislators concede that they are trying to game the system. But they argue that Congress left them little choice.”).

Under one potential strategy, a state would allow a resident to replace her state income tax payments with charitable contributions. Though the final details of this strategy remain to be seen, a state might offer a dollar-for-dollar income tax credit for any taxpayer who makes a charitable contribution to the state. For example, a taxpayer with a $25,000 state income tax liability would donate $25,000 to a state educational fund and receive a state income tax credit for that donation. In terms of payments to the state, the taxpayer will be no better or worse off — what she would have paid in income taxes to the state revenue department will have instead been paid (donated) to the state educational agency. But the strategy, if it works, would establish a federal tax benefit. The taxpayer’s $25,000 donation would give rise to a federal charitable contribution and could usually be deducted in full. See §§ 170(a) (establishing a federal income tax deduction for charitable contributions) and 170(c)(1) (contributions to states and their subdivisions qualify as charitable contributions, when made for exclusively public purposes). The taxpayer would thus avoid the $10,000 limitation that would apply under Section 164.

Whether the charitable contribution strategy works will depend on the details of a given state’s plans, but there are unquestionably some serious legal and practical obstacles. If a taxpayer has a fixed state income tax liability but receives a credit against that liability for any payments directed to state agencies or subdivisions, it is hard to see why the characterization of the payment will change. Does a payment that would be a tax really become a charitable contribution simply because the taxpayer writes “State X Educational Agency” on her check rather than “State X Revenue Department”? The total amount she must pay to the state, after all, is computed under the state’s tax laws, regardless of the state agency to which she transfers a payment.

Also, the regulations under Section 164, in defining the payments covered by the statute, look to the substance of a payment to determine whether it is a tax, rather than the form through which it is collected. See Treas. Reg. § 1.164-3. See also Campbell v. Davenport, 362 F.2d 624, 628 (5th Cir. 1966) (“‘whether a particular contribution or charge is to be regarded as a tax depends upon its real nature’”) (quoting Rev. Rul. 57-345). Thus, for example, a payment made to a state’s motor vehicle department, nominally to register one’s vehicle, will actually qualify as a vehicle tax if the amount charged by the state depends on the value of the car. See Treas. Reg. § 1.164-3(c)(3) (“[A]n annual ad valorem tax qualifies as a personal property tax although it is denominated a registration fee imposed for the privilege of registering motor vehicles or of using them on the highways.”). See also IRS CCA 200435001 (Aug. 27, 2004) (an amount nominally donated to a state but which fails to qualify as a Section 170 charitable contribution arguably “should be viewed as a payment of state tax”).

Though the cited authorities call for a holistic analysis, they do not squarely resolve the federal income tax characterization of a purported donation made to a state in lieu of an income tax payment. In a memo released in 2011, an attorney in the IRS National Office explained to a field office attorney that, in specific circumstances, a taxpayer’s payment to a state subdivision would qualify as a charitable contribution under Section 170, even though that payment established a credit against the taxpayer’s state income taxes. See IRS CCA 201105010 (Feb. 4, 2011). However, in that memo, the taxpayer had the option to make donations and receive state tax credits for payments not only to the state itself, but also to non-state organizations. Thus, the statutory regime did not simply encourage taxpayers to shuffle around their mandatory payments (taxes) to different instrumentalities within a single government, as do various current proposals.

Under Section 6110(k)(3), the 2011 memo cannot be cited as precedent. It also does not reflect the IRS’s official position, and other agency attorneys have acknowledged the potential issues here. See IRS CCA 200435001 (“a payment for which a benefit of receiving a state income tax credit may be expected raises serious concerns as to the deductibility of such a payment as a charitable contribution”). And if a state uses the statutory regime described in the 2011 memo as a model, it will face practical risks. Allowing taxpayers to contribute to state instrumentalities or non-state organizations will lead to decreased revenues, because some residents will surely direct their dollars to the latter group.

Whether any state officials carry through on their promises to game the federal tax system remains to be seen. But, absent official guidance from the IRS, states that adopt the charitable contribution strategy face substantial uncertainty. And it will be impossible for them to provide reliable guidance to their residents on the federal tax treatment of their donations. Other issues, beyond those considered here, also linger, including whether a dollar-for-dollar tax credit presents the sort of quid pro quo that would take a payment out of Section 170. Perhaps most dangerously, Congress could respond to the states’ gamesmanship by making donations to states ineligible for the Section 170(a) deduction. 

[UPDATE #1:  On May 23, 2018, after various states proposed or enacted measures to circumvent Section 164’s limits through nominal donations, the IRS issued a notice expressing it intent to issue regulations on the subject and warning taxpayers to be “mindful” of substance over form principles. See Notice 2018-54.]

[UPDATE #2:  For my full-length law review article on the issues raised by charitable contribution strategy, please see here.]

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About Andy Grewal

Law Professor, University of Iowa

9 thoughts on “Can States Game the Republican Tax Bill with the Charitable Contribution Strategy?

  1. Kenneth H. Ryesky

    Carrying the strategy a step further, why not declare all payments to hospitals as charitable donations (there was a time in the not-so-distant past when almost all hospitals were in fact eleemosynary entities)? Why not individual physicians (or dentists or optometrists)?

    Reply
  2. Andrew Dhuey

    Thank you for an interesting and thoughtful piece, Professor Grewal, and congratulations on having such an excellent first name.

    Question for you: doesn’t your rationale here conflict with how generally 100% of a donation to a state/local government is a valid federal charitable deduction? Under previous law, if a California taxpayer donated $1,000 to a local school district, that was unquestionably a valid $1,000 federal charitable deduction (assuming no personal benefit such as sports tickets, etc.). But that taxpayer’s “fixed state income tax liability” (your language, above) might be reduced by as much as $103. Under your analysis above, shouldn’t this taxpayer’s federal deduction be $897, not $1,000?

    Reply
    1. Andy Grewal Post author

      Thank you for reading and for the thoughtful comment.

      If you simply gave $1000 to your local school, yes, that would generally qualify as a charitable contribution under Section 170 of the federal tax code, regardless of whether you also enjoyed a state tax benefit. No one would argue that you had really paid taxes to the state or locality.

      But the current proposals are different. They’re dealing with situations where the tax laws of the state have established your $1,000 tax liability. Then, the state is proposing to tell you to just mail your payment (donation) to the “State Excellence Fund” rather than the state revenue department. On these facts, your $1,000 still reflects the payment of taxes and is not a freely given charitable donation, as argued in the post.

      Reply
      1. Andrew Dhuey

        Thanks! Okay, what if we tweak it so that the money goes to a special list of 501(c)(3), organizations. On this list are orgs that perform various social services for a municipality (e.g., operate a homeless shelter) for which they receive large payments from the city. For every dollar you pay these orgs (and let’s say the gift must be restricted to pay for these civic services), you get a dollar reduction in your property tax bill.

        Same problem?

        Reply
      2. Andrew Dhuey

        I should add that I had in mind an agreement between the city and the orgs providing that all monies they receive under this scheme reduce, dollar-for-dollar, money the orgs get from the city under the services contract. In other words, it’s a wash for the city and the orgs.

        Reply
        1. Andy Grewal Post author

          If a state offers tax credits or tax deductions for amounts donated to entities not affiliated with a state, I don’t see any issue. Of course, this option isn’t broadly appealing because it threatens the state’s coffers.

          If, as a corollary, the state says it will shrink payments to these 501c3s on account of any donations they receive, maybe that might work, although it sounds rather confusing and complex to implement. (Do donors have to tell the 501c3’s they’re planning to take a tax credit regarding their donation? Will orgs encourage donors not to claim credit, so org itself won’t get a haircut from the state? Will the financial relationship between the state and the org because to close that the org itself becomes considered a state entity?)

          Reply
          1. Shelby Clark

            I’m a California business attorney, not a tax specialist. It seems to me any effort that relies on known mechanisms to avoid federal tax atop SALT are more likely to result in those mechanisms being invalidated than in actual avoidance of federal taxes on SALT payments. There is a long history of people claiming a taxable expense is really not taxable, and of that claim being defeated.

  3. Eric Rasmusen

    I think donations to autonomous non-state organizations would be the way to go. What most analyses miss is that the biggest problem is that the recipient can’t give something of value to the donor, and the examples usually cited (tax credits for donations to school scholarhip funds, or even tax credits for donations to school districts) don’t do that— it is a third party, the state, giving something to the donor for making the donation to the recipient. See
    Getting Around the State and Local Tax Deduction Limit (January 9, 2018). Available at SSRN: https://ssrn.com/abstract=3099296. Also, http://rasmusen.dreamhosters.com/b/2018/01/additions-for-my-state-tax-paper-reciprocity-sullivan-and-pease/

    I still would worry about form over substance. That would probably not be a problem if the credit is not for 100% or the funds do not replace state appropriations one for one.

    Reply
  4. Andrew Szymulanski

    This author’s humble view is that the “contribution in lieu of tax” works…under present law (April 2018). Our state just took the initial step to pass such a measure.
    – it does not matter whether the contribution is to a different legal entity than the one giving the “benefit,” because…
    – the benefit is treated as having zero value as a matter well-settled and long-standing federal tax law.
    – the “substance over form” argument will be a very difficult one for the IRS to sustain. No precedent exists to support that line of attack in this context.
    http://www.laurentiangroup.com/2018/04/24/charitable-gifts/
    All of the above is of course “IMHO,” as they say.
    Best,
    Andrew

    Reply

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