State Responses to New Limits on the State & Local Tax Deduction: Evaluating the Options
State and local taxes aren’t just for “law professors and bloggers” any more. As the New York Times tells us, the States are scrambling to respond to Congress’ recent tax legislation — which, thanks to the Senate Parliamentarian, we can call The Thing With No Name (“TWNN”). In addition to a likely wave of decoupling, in which states whose tax codes mirror federal law disclaim what they deem unwise recent amendments, states (and I hope, for the sake of my bank balance, the District of Columbia) will be trying to counteract the fiscal impact of new limits on the state & local tax deduction (herein, “SALT”).
To refresh your recollection, TWNN caps the federal deduction for tax paid to state & local governments at $10,000 of taxable income. Many households in the top 2–3% of income regularly claim several multiples of that number currently, suggesting that state collections for those families are about are get about 30% more costly. For instance, let’s say Brian lives in D.C. and earns $1 million (this is, ahem, hypothetical). He pays about $100,000 in taxes to D.C. Formerly, this would have allowed him to reduce his federal taxable income to $900,000, saving him, let’ say, 30% x $100,000, or $30,000. The new cap will cut this deduction to $10,000, costing him $27,000 (since his new federal taxable income will be $990,000). We’ll shed no tears for Brian (or you won’t, anyway), but he may not bear the ultimate economic burden of the TWNN cap. If pressure from Brian and his neighbors forces D.C. to cut taxes, the new cap may in fact take money from schools, police precincts, or other safety-net spending around the city.
So there is some urgency, at least politically, for states to act. There are a handful of proposals, each with relative strengths and weaknesses. Over the next few posts, I’m going to try to survey them. I’ve given each contender a handy nickname: charity at home, repeal and replace, and salary upcycling. Let’s start with the proposal highlighted in the Times…
Charity At Home
What I’ve called the “charity at home” plan would grant a 100% credit against state income taxes for any charitable contribution to the state government (or perhaps a subdivision of donor’s choice). The anointed public face of this proposal is friend of this blog Kirk Stark, the UCLA professor. Charitable contributions are formally still just about as deductible as before (in some cases more so, since TWNN uproots the Pease phaseout on itemized deductions that formerly hit some high-income taxpayers). Thus, charity at home allows a taxpayer to “pay” her state taxes in a form that allows her to reduce her federal tax bill. Though TWNN’s expanded standard deduction will likely curtail the incentive to itemize for moderate-income households, these families are unlikely to be affected by the $10,000 SALT cap. So the plan maintains deductibility for most households that would otherwise lose a part of their deduction.
For instance, suppose in 2017 Kirk earns $1m, paying 10% to CA and 30% to the U.S. Kirk’s total taxes are $100K to CA, then 30% * ($1m — $100k) = $270k to the U.S. Under TWNN, in 2018, he pays 30% of $990k, resulting in an extra $27k of tax liability. With charity at home, Kirk would donate $100k to CA, yielding a $100k credit against CA tax, resulting in $0 CA tax. He would get a $100k federal tax deduction, for $900k in federal taxable income, reducing Uncle Sam’s share to its 2017 level, $270k.
The plan has potential roadblocks both legal and practical. Legally, charitable contributions are supposed to be…well, charitable. A donor must reduce the value of her deduction by the value of any benefit she receives in exchange for her gift (aside from benefits available equally to the public). One might think that getting a 100% tax credit from the very entity receiving the donation (or one that at least controls the recipient school or agency) would therefore eliminate the donor’s deduction. So far, though, similar plans of more limited scope (generally granting state tax credits for donations to schools in places like CA and SC) have successfully obtained rulings agreeing that donors would still retain their full deduction. Several court decisions at least implicitly seem to accept this position.
The problem, then, is that an unsympathethic IRS could fairly readily shut down the charity at home plan. The current rulings are informal field guidance that have no precedential force. Given the already-dubious legal position behind current credit schemes, there is little question that the IRS could reverse ground. Moreover, the current opinions depend on the impact of state credits on the federal SALT deduction, and warn that “[t]here may be unusual circumstances in which it would be appropriate to recharacterize a payment of cash or property that was, in form, a charitable contribution as, in substance, a satisfaction of tax liability.” At worst, a court challenge could force the IRS to take the time to issue new guidance through notice & comment — its position would almost certainly be found at least to be “reasonable,” so a ruling issued with notice and comment would prevail under Chevron.
The practical obstacles are less thorny, but probably should be worked through carefully before any state proceeds. One is simply a budgeting question: if donors can choose specific sub-components of government as targets of their “largesse,” how will the state ensure that budgeting remains largely under control of state officials? Appropriations could be offset on a rolling basis by donations — unless some departments were overfunded by donors — or donations could be held for use in the following fiscal year, allowing budgeters to plan in response.
Another is the timing of the donation. Donors who want to offset all or nearly all their state income will need to know what that income is before making their donation. That will be typically occur after the federal tax year has ended. Taxpayers with fairly steady incomes might not be much affected, but those with large fluctuations will have more trouble. Taxpayers who plan a donation will be forced, in essence, to over-withhold state taxes during the course of the year, and might not have cash on hand in December to make a donation large enough to offset all that has been withheld. One fix could be to implement a kind of donation withholding, in which employers provide a payroll offset for rolling contributions to a donor advised fund or the like, with these bi-weekly contributions allowed to reduce required state withholding.
Next up: Should states repeal their income taxes and replace them with payroll levies?