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: 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.]
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