Treasury’s SALT Regulations
Fixing What They Can
Treasury recently released regulations targeted at one of the strategies states are using to try to effectively maintain the deductibility of state and local taxes paid byindividuals. The regulations aim to stop states from doing so by creating charitable donation programs. These are programs in which residents give money to certain funds or organizations, take a charitable deduction for their giving, and then receive a tax credit — often nearly a one-for-one credit — reducing their state taxes in return. As a result, non-deductible state and local taxes get replaced by what is ostensibly charitable giving.
Treasury’s proposed regulations aim to stop these maneuvers by applying the quid pro quo doctrine to state and local tax benefits. Where applied (and it is applied inconsistently), the quid pro quo doctrine suggests that the amount of the charitable deduction is the difference between the value of what someone gives to a charity and what they get back in return if anything. It hadn’t previously been extended to state tax benefits, but the proposed regulation does so if those benefits exceed certain de minimis thresholds.
The question then is whether Treasury has the authority to take this action. My view is that it does have the discretion to go in this general direction, despite this representing a significant change in the treatment of state tax benefits. To be sure, the SALT cap is still deeply flawed, but, here, Treasury went in a reasonable direction given the mess it was handed. Key is that Treasury chose to treat the old tax credit programs in often “red” states the same as the new tax credit programs in the “blue” states. The possible alternative of discriminating between the red-state and blue-state programs would likely have been based on arbitrary and capricious reasoning in my view and thus should have been struck down by the courts.
However, Daniel Hemel — my co-contributor to Whatever Source Derived — has raised a possible objection to these proposed regulations. In particular, they treat federal and foreign tax benefits differently from state and local tax benefits; the quid pro quo doctrine apparently isn’t extended to them. While Daniel doesn’t claim this to be an open and shut argument, he suggests that this difference in treatment of tax benefits is plausible grounds for challenging the regulations as exceeding Treasury’s authority.
While a court might buy the logic Daniel lays out, I don’t think it should, certainly when it comes to the federal tax benefits, which are the big deal. In my view, Treasury — if it explains itself — should be on solid ground distinguishing the federal tax benefit from the state and local ones, and not reducing the charitable deduction for the former even as it does for the latter. I agree with Daniel that the treatment of foreign tax benefits under the regulations seems worth revisiting, even as there are some ways to justify the proposed treatment.
Why a Quid Pro Quo for State Tax Benefits but Not Federal Ones
The federal write off for charitable giving of course provides a tax benefit in exchange for giving. Daniel is arguing that, given how state and local tax benefits get treated, Treasury may have to apply the same treatment to this federal benefit.
An example would help illustrate. Imagine someone in the top federal tax bracket of 37 percent and who itemizes. They give $1 to a qualified charity, and then take their deduction worth 37 cents. Daniel is suggesting that the deduction must be reduced by that tax benefit. This becomes iterative, and, if you work through the math, the federal deduction would get reduced to 73 cents — as 27 cents of the $1 of giving (73 cents X 37%) would represent the federal tax benefit.
The proposed Treasury regulation doesn’t treat the federal tax benefits in this way. This is even as it requires certain state tax benefits above a de minimis to be offset. Any state of local tax credit for charitable giving in excess of 15 percent per dollar contributed must be offset. The value of state and local charitable deductions actually don’t have to be offset so long as the deduction is equal to or less than the fair market value of the property contributed, but the point is that some of these state tax benefits — and ones that are even less per dollar than the benefit of the federal deduction — would have to be offset.
However, there are good reasons that Treasury can offer to distinguish federal and state tax benefits and that are consistent with the statutory scheme.
Specifically, the very nature of the charitable deduction is to provide a federal tax benefit. It is thus reasonable in my view for Treasury to not apply the quid pro quo doctrine to that benefit and rather see that tax subsidy as targeted at giving where someone doesn’t get a benefit from another party. So, if someone really does give $1 to a charity and gets nothing back in return, then the federal government kicks in 37 cents to try to encourage that kind of giving. Sure, there’s a tax benefit from the federal government , but that’s the very idea — the federal government, for better or worse, wants to encourage this kind of giving and so is subsidizing it.
By contrast, the federal government is presumably not trying to encourage transactions where someone is getting back something of monetary value from a third party, whether that be a state or anyone else. Thus, requiring certain state and local tax benefits to reduce the federal deduction is about the targeting of the federal subsidy on transactions where there isn’t a quid pro quo from a third party.
Another way to put it is this: The current federal tax benefit for charitable giving is “tax inclusive.” It means that, for someone in the top tax bracket, they get 37 cents on the dollar given to charity with the dollar including the federal tax benefit. Daniel is arguing that, given the proposed treatment of state and local tax benefits, it must in fact be 37 cents per dollar, tax exclusive (excluding the federal benefit for the dollar). However, assuming an ability to adjust the federal subsidy rate, it effectively doesn’t matter whether a system is tax inclusive or tax exclusive — you can achieve the exact same results either way so long as you set the rates correctly. For instance, a 37 cent per dollar tax inclusive subsidy is exactly equivalent to a 59 cent per dollar tax exclusive subsidy.
In my view, it is well within Treasury’s discretion to maintain the long-standing treatment of the federal charitable deduction as a tax-inclusive federal subsidy and not force Congress to adjust rates to achieve the exact same results. That’s even as Treasury treats state tax benefits as a quid pro quo.
Importantly, Treasury does not actually offer this justification in the proposed regulations. Especially as the regulations could be challenged on this basis and given the restrictions on post hoc rationalizations, it would be well worth it for Treasury to address this issue head on in the final regulations. I think Daniel and I agree on that much!
What About Foreign Tax Benefits?
Justifying the very different treatment of foreign and state and local tax benefits is harder, though there are still some possible ways to differentiate. As a result, Treasury should consider putting them and state and local tax benefits in the same bucket. That presumably would be much easier to do than the federal tax benefits, as it would not mean a fundamental change in how the tax subsidy for all eligible charitable giving works.
The foreign countries after all are third parties, just like state and local governments. To the degree the basic logic is that the federal subsidy is targeting when people give to charities more than they receive from third parties in return, then the tax benefits from foreign governments and state and local governments should seemingly be treated the same.
Still, there could be ways to justify the difference in treatment in the current regulation. Importantly, foreign taxes have long been treated differently than state and local taxes in other parts of the tax code. For instance, there is a foreign tax credit that provides a credit of up to one-for-one for foreign taxes paid on income also subject to tax in the United States. To the degree that foreign taxes are (rightly or wrongly) treated as substitutes like this for federal taxes, then that distinguishes them from state and local taxes, which are not. Is it enough to justify the difference in treatment in the proposed regulation? Perhaps — though Treasury would probably be on safer ground throwing foreign tax benefits in with state and local ones.
The Cap Is Still Broken
The regulations may be generally reasonable, but the SALT cap is not. There remain ways in which states can avoid the cap, even if this particular regulation is upheld — namely shifting to payroll taxes from income taxes and shifting to entity level taxation on pass through entities. Some states are already doing that. And, as a policy matter, I have a hard time justifying the now vast difference in tax treatment in taxes for public schools versus giving to private ones. To sound like a broken record: Congress should revisit the SALT cap and itemized deductions generally for fundamental reform. But, that doesn’t change the fact that these proposed regulations have gone in a generally reasonable direction.