Two Cheers for IRS Guidance on the New SALT Cap
But let’s not pre-judge the regulations before we see what they say
Yesterday’s notice by the Treasury Department and the IRS that they plan to propose regulations related to the state and local tax (SALT) and charitable contribution deductions has generated lots of news coverage. Some of those stories, like Naomi Jagoda’s excellent report in The Hill, accurately describe the announcement. Others do not. Headlines declare that the IRS is “tak[ing] aim” at state proposals, that the agency has “warn[ed] states not to circumvent” the state and local tax deduction cap, and that it is planning “to crack down” on blue states. Most reporters do not write their own headlines, so I hold them harmless. But I think it’s important that state lawmakers and taxpayers not misread — or overread — yesterday’s release.
Let’s start with what the notice did say. First, it revealed — and this is new news — that Treasury and the IRS “intend to propose regulations addressing the federal income tax treatment of certain payments made by taxpayers for which taxpayers receive a credit against their state and local taxes.” That’s apparently a reference to laws already enacted in New Jersey, New York, and Oregon that allow taxpayers to claim a state tax credit for charitable contributions to certain state-affiliated funds, as well as several similar proposals pending in other state legislatures. Interestingly, Treasury and the IRS signaled no intention to issue regulations addressing New York’s new “Employer Compensation Expense Program,” which allows employees to claim a state tax credit if their employer opts into a new payroll tax regime. Even those who are skeptical of the charitable credit arrangement acknowledge that the payroll tax shift “almost certainly” will pass muster under federal tax law, and nothing in yesterday’s notice suggests otherwise.
I think it’s good news that Treasury and the IRS will be coming out with regulations regarding state charitable credits (with the caveat that tax regulatory projects can sometimes take years and don’t always come to fruition). Thus far, states and taxpayers have been relying on a 2011 memorandum from the IRS’s Office of Chief Counsel stating that “[g]enerally,” donations to state programs are deductible for federal purposes as charitable contributions — notwithstanding the fact that the donor receives a state tax credit — provided that the other requirements of section 170 of the Internal Revenue Code are satisfied. The problem with relying on a chief counsel memorandum is that those memos specifically say they “may not be used or cited as precedent.” A clarifying regulation will help states plan their fiscal futures and will help taxpayers organize their financial lives.
There is another important difference between a Treasury regulation and advice from the IRS chief counsel. Regulations can be challenged in court; chief counsel memos usually can’t be. If Treasury issues a regulation barring taxpayers from claiming a charitable contribution for donations to state credit programs, then states will likely have their day in court quite soon. The key precedent on this point is South Carolina v. Regan, which involved a statutory change in 1982 that ended the federal income tax exemption for interest on state and local bonds issued in bearer rather than registered form. The Supreme Court held in that case that South Carolina could challenge the new law notwithstanding the fact that its taxes weren’t affected, and notwithstanding the existence of an 1867 law, the Anti-Injunction Act, which generally bars pre-enforcement challenges to tax regulations. The repeal of the exemption for bearer bonds reduced the value of debt that South Carolina issued in that form, and the state would have no other opportunity to challenge the change. The Court’s rationale in Regan would apply four-square to a hypothetical state challenge to a Treasury regulation limiting the deductibility of donations to state credit programs: the regulation would make credits issued by states less valuable, and the states would have no other opportunity for legal recourse.
Of course, no state can or will challenge Treasury regulations unless those regulations negatively affect state credit programs. And Treasury and the IRS haven’t yet told us what their regulations will say. Yesterday’s notice states that “federal law controls the proper characterization of payments for federal tax purposes” (well, of course it does) and that “substance-over-form principles” are relevant (well, of course they are). But as a number of other tax professors and I have argued, the best reading of existing federal law is that donations to state-designated charitable funds are deductible as charitable contributions as long as they meet the substantive and formal requirements for deductibility — whether or not the taxpayer receives a state tax benefit.
Consider, for example, the Bridget “Biddy” Mason Golden State Credit Program, passed this month by the California State Assembly’s Revenue and Taxation Committee (but not yet acted upon by the Assembly’s Appropriations Committee or the State Senate). Under that program, a taxpayer can give $100 to a K-12 public school district, community college, public university, or public charity active in California and receive 100 Golden State Credits. The school, community college, university, or charity can obtain those 100 Golden State Credits by transferring $90 to the state’s general fund. The 100 credits allow the taxpayer to offset $80 of state tax liability.
Under federal law, should the taxpayer’s $100 donation be treated as a $100 charitable contribution or a $100 state tax payment (or as something else entirely)? Well, section 170 of the Internal Revenue Code says that gifts to states and their subdivisions and to charities are deductible as charitable contributions, subject to a number of requirements related to substantiation and other matters that the Golden State Credit Program participants will surely meet. Yes, $90 of that $100 is transferred to the state general fund, but should that change anything? After all, public schools, community colleges, state universities, and many charities receive lots of funding from the state; in substance, the Golden State Credit Program is no different from an arrangement in which the state provided a charitable contribution credit of 80 cents on the dollar and cut state funding by 90 cents for every dollar received by the donee. An 80-cents-on-the-dollar charitable contribution credit is a big credit, but it’s actually less than the value of the deduction that taxpayers in the top bracket received when they donated to charity between 1940 and 1963 (when the highest marginal rate was above 80%). Indeed, at the time that Congress codified section 170 as part of the Internal Revenue Code of 1954, it certainly contemplated that charitable gifts could be deductible even when the tax benefit was greater than 80 cents on the dollar.
To be sure, the combined federal and state tax benefits of participating in the Golden State Credit Program may be more than 80 cents on the dollar for some taxpayers. For a taxpayer in 37% bracket who hits the $10,000 SALT cap, every $1 contribution generates 80 cents of state tax benefits and a federal tax deduction of 37 cents, for a total of $1.17. But there is nothing new there either. Back in 1954, the top statutory tax rate on ordinary income was 91%, and the tax rate on long-term capital gains was 25%. A taxpayer holding a zero-basis asset with a fair market value of $100 would have had a choice: give it to charity and get a tax deduction worth $91, or sell it and be left with $75. (Holding onto it until death was probably the worst option, because the top estate tax rate at the time was 77%.) So a taxpayer’s best financial move was to give the asset to charity before she passed away. Congress knew at the time that it incorporated section 170 into the 1954 Code that charitable contributions would sometimes be tax-efficient relative to all the alternative dispositions. Does that mean that high-bracket taxpayers who claimed the charitable contribution deduction were doing so improperly for decades? No, because throughout the history of the U.S. federal income tax, the tax benefits of a charitable contribution have been disregarded when calculating the amount of the corresponding deduction.
Does anything in yesterday’s notice indicate that the regulations contemplated by Treasury and the IRS will disallow charitable contribution deductions for Golden State Credit Program participants? I’ve re-read the notice several times and I can’t find anything to that effect. Concededly, it’s possible that Treasury and the IRS will fashion a new federal tax law doctrine that distinguishes between Golden State Credit contributions and donations that have been deductible for decades. But that is certainly not what the Service said yesterday, and we do a disservice to state lawmakers and taxpayers if we tell them otherwise.