The tax war between a Republican-controlled federal government and high-tax, high-income states did not end with the passage of the GOP tax bill on December 19. Now Democratic leaders in California, New Jersey, and New York are designing “workarounds” to reduce or even eliminate the impact of the federal bill’s $10,000 cap on the deductibility of state and local (SALT) income, and sales and property taxes.
The most clearly defined “workaround” has been introduced as a bill by California’s State Senate president pro tem Kevin de Leon.
The state legislation would create a state-run nonprofit, the California Excellence Fund, to accept donations to fund schools, road repairs and everything else in the state budget. The donations would allow residents to reduce their state income tax payments and also receive a federal charitable tax deduction.
The simple idea is to shift state income tax payments for those who wish to go in this direction to the state-run nonprofit, and also leave “cap” room for property tax payments under the new $10,000 federal limitation for SALT deductions.
An impressively large group of Californians might benefit from this strategem, typically upper-middle income folk with sizable state tax liabilities:
About 2.5 million single and joint filers in California — comprising 15% of all returns — claimed more than $10,000 in state and local tax deductions in 2015, the most recent data available, according to the state Department of Finance. Nearly 90% of those filers reported annual incomes of $100,000 or more.
Bestowing relief upon this category of taxpayers might help California Democrats — and particularly de Leon, a U.S. Senate candidate with a lefty reputation — continue to improve their performance among college-educated upscale voters. And it might erode Republican opposition, though de Leon’s plan could be passed by simple majorities in both the state’s Democratic-dominated state legislative chambers.
In his State of the State address New York governor Andrew Cuomo suggested he was looking at a similar charitable-contributions scheme. He’s also reportedly examining ways to reduce the state’s reliance on income taxes, possibly by greater use of payroll taxes, which remain fully deductible in the federal tax system. And more immediately, Cuomo is filing suit against the Feds to stop the new bill’s changes to SALT deductibility, on multiple constitutional grounds.
And in New Jersey, where local property taxes are a much bigger concern than state income taxes, incoming Democratic governor Phil Murphy and two Democratic congressmen have floated a proposal to create a charitable foundation similar to the one being contemplated for California and New York, but with property-tax purposes targeted and a new state tax credit created against property-tax liability.
Everyone understands that the IRS is likely to fight these schemes on two grounds — by questioning the charitable purpose of the new system, which is transparently designed to get around a federal tax change; and by arguing that any charitable deduction should be offset by the tangible value of the state tax credit (i.e., entirely). There is, however, precedent for similar, if less sweeping, proposals, as Bloomberg reports:
Wealthy taxpayers already use a similar ploy in 18 states that offer at least partial tax credits in return for donations to nonprofits that grant tuition vouchers to private and religious schools….
In a memo released in 2011, the Internal Revenue Service gave its blessing for taxpayers to claim federal deductions on those gifts. The combination of a 100 percent state-tax credit and a federal deduction actually makes the gifts profitable for some donors, said Carl Davis, research director for the Institute on Taxation and Economic Policy.
It’s hard to see how this differs from what de Leon is proposing, aside from its scale and its ideological framing.
The same Congress that passed the tax bill could, of course, amend it to outlaw such schemes. But it would no longer be able to use the special budget rules that made it possible to pass the legislation by a simple party-line majority vote. So that’s unlikely.
But as workarounds become tangible, we will definitely hear a drumbeat from conservatives nationally and in the affected states that the real solution is to cut taxes and spending at the state level — to adopt, in other words, Republican policies.
There is a sense of urgency about sorting these matters out since the charitable contribution workaround relies on people beginning to make their “donations” in 2018, when the SALT cap takes effect. So you can expect some lawyers on both sides of this issue to burn some midnight oil early this year.