Of the state and local tax deduction workarounds proposed by several high-tax states, allowing taxpayers to claim state tax payments as donations in order to claim the federal charitable deduction seems the likeliest to succeed.
The unusual strategy would allow taxpayers to donate the amount they owe in state taxes to a state fund in return for an equivalent state tax credit. Taxpayers could then claim the federal charitable deduction for the amount donated. States would collect the same revenue they do now, and taxpayers could circumvent the federal Tax Cuts and Jobs Act's $10,000 SALT deduction cap.
Existing precedent and regulatory guidance suggest the workaround could withstand legal and legislative challenges, according to Adam Thimmesch, a tax expert and professor at Nebraska College of Law. His comments came during a panel discussion February 9 at the 2018 mid-year meeting of the American Bar Association Section of Taxation in San Diego.
Thimmesch said that according to a 2010 IRS chief counsel advice memorandum (CCA 201105010), donations to state governments qualify for the federal charitable deduction. The memo also says, however, that there are some unusual circumstances in which a donation to a state government would be treated by the IRS as a form of payment to satisfy a state or local government tax liability, which would not be federally deductible as a charitable donation. Thimmesch said he’s confident that some versions of the proposal — such as California’s S.B. 227, which has been amended to offer just under a dollar-for-dollar credit to minimize the risk of being struck down — could withstand challenge if done right.
Thimmesch also referred to the U.S. Supreme Court's 2011 opinion in Arizona Christian School Tuition Org. v. Winn, which supported the idea that donors receiving state tax benefits in return for donating to a state-supported cause don’t need to make a proportionate reduction to the federal charitable deduction they claim.
According to Thimmesch, the proposed workaround is similar to existing programs, largely backed by conservative Republicans, that allow taxpayers to claim credits against their state tax liability in return for donations to private school tuition funds. Taxpayers then deduct the donations from their federal taxes. Assuming the proposal withstands legal scrutiny, the similarity could protect the SALT workaround from attempts by the majority-Republican Congress to counter the strategy with federal legislation that could threaten the private school donation programs as well, he said.
“We know [Republicans] would like to shut this off. The big question is 'how do you do it without losing other things that [Republicans] like?'” Thimmesch told attendees.
According to Nikki Dobay, senior tax counsel for the Council On State Taxation, Oregon’s legislature is moving forward with a bill that's similar to California S.B. 227. She said Oregon lawmakers are cavalier about the risks, which she said would fall on the taxpayer, not the state.
“They’re saying ‘it might not work at the federal level . . . but if the taxpayer wants to take the risk, we’ll let them,'” Dobay said.
A Shift to Payroll Taxes
Another proposed workaround, replacing state income taxes with employer-side payroll taxes, could prove too administratively complex, according to panelists. Theoretically, businesses would deduct the tax from their federal taxes as an expense, which isn’t subject to the SALT cap, and the shift from payroll to income taxation would ease the state tax burden on income earners whose federal SALT deductions are now limited.
Dobay criticized the proposal as being hard to implement, but she also said the payroll tax idea would be harder for the IRS or congressional Republicans to shut down because the tax is still being paid, just by an employer rather than an employee.
According to Thimmesch, there are many unanswered questions regarding how swapping out an income tax with a payroll tax would work. Businesses would likely adjust wages downward in light of the new tax, he said, and states would have to either eliminate or reduce employees’ income taxes, potentially providing state income tax credits to employees at the same rate as the new employer-side payroll tax, which could complicate efforts to appropriately target the state tax relief.
“One way that’s been proposed, at least in New York, is to only impose this for incomes above $200,000,” Thimmesch said. But, he added, “there are uniformity issues . . . and all sorts of complications.” He also said employees could oppose the complicated plan because of its likely impact on wages, despite the larger goal of benefiting individual taxpayers.
Michael Lang, a tax expert and professor at Chapman University, questioned how the payroll tax proposal would address owners of passthrough businesses. “As an administrative matter [this plan] is fairly complicated, I think it’s safe to say,” Thimmesch responded.
Dobay noted that while states have been discussing how to help taxpayers avoid the potential tax burden caused by the new SALT cap, they’ve been quieter about another outcome of the base-broadening federal tax reform — the potential windfall for state coffers. Since most states use federal income tax rules as the basis for calculating state income taxes, the elimination of numerous federal deductions for purposes of calculating taxable income means states will be taxing a greater percentage of taxpayers’ income. But unlike the federal government, state tax rates haven’t been reduced.
“They’re kind of just [saying] ‘nothing to see here!’” Dobay said.
However, Thimmesch said Nebraska lawmakers have talked about passing legislation to avoid collecting more taxes as a result of the federal reform.
Notably, some states have proposed a legal challenge to the SALT cap. Potential legal strategies include a claim that the SALT cap violates the equal protection clause by creating a federal tax regime that discriminates between states, and a claim that the cap impinges on states' ability to self-govern by ratcheting up pressure on high-tax states to alter their tax regimes.
“For the most part, commentators have said these are very weak arguments,” according to Dobay.