High-tax states are looking for ways to "outmaneuver" the new federal tax law's $10,000 cap on the state and local tax deduction, though experts are warning of legal and practical challenges.
The new law, known informally as the Tax Cuts and Jobs Act, has many high-tax states like California, Maryland, New Jersey, and New York scrambling to figure out how to mitigate the tax increases expected to affect some taxpayers.
A California bill (S.B. 277), for example, would allow residents to make charitable contributions to a new California Excellence Fund to be used for public purposes specified under IRC section 170. Taxpayers could claim the amount as a dollar-for-dollar tax credit against state income taxes owed, and could also deduct the donations from their federal taxes. The bill was introduced January 4 by Senate President Pro Tempore Kevin de León (D).
States could also replace their income taxes with employer-side payroll taxes and a refundable credit for individuals, according to a November 9 blog post by Daniel Hemel, assistant professor of law at the University of Chicago.
New York Gov. Andrew Cuomo (D) said in his January 3 state of the state address that he is considering a similar employer-side payroll tax to reduce the state’s reliance on its income tax.
But Matthew Gardner of the Institute on Taxation and Economic Policy told Tax Analysts that there are a lot of uncertainties about both proposals because implementing either on such a large scale would be unprecedented. He said that although he thinks the ideas are worth considering, policymakers should "definitely take time to think through the indirect effect of implementing these changes," and also consider how Congress would react.
Meanwhile, a January 5 Tax Foundation report said the proposals would be unlikely to succeed because of legal and practical barriers, and recommended that states instead lower tax rates. Report author Jared Walczak said the charitable contribution strategy would be problematic because the purpose of the contributions would be for financial gain, and "case law and IRS regulations generally require charitable intent for a contribution to be deductible."
Walczak cited several court cases that he said present barriers to the strategy, including the U.S. Supreme Court decisions in United States v. American Bar Endowment, Singer Co. v. United States, and Hernandez v. Commissioner.
As for the payroll tax swap proposal, the report said it could face scrutiny from the IRS and might also be unconstitutional in states like Illinois, Massachusetts, and Pennsylvania, where courts have strictly interpreted uniformity clauses. States could face significant political resistance to the plan because of concerns about how it would be applied, according to the report.
Gardner said it could be difficult to preserve the more progressive features of state income taxes if they are replaced by employer-side payroll taxes, and said the harm to low-income taxpayers would outweigh any benefits received by itemizers.
"This entire debate was caused by the way Congress chose to limit the SALT deduction without really thinking through the impacts on fiscal federalism," Gardner said.