Brace For the Impact Federal Tax Cap on State and Local Deductions

Will new charitable tax credits being considered by California and other states have any impact on the 2017 federal tax overhaul’s cap on state and local deductions? Some say yes, these will work with certain qualifications.

Law professor David Gamage and seven tax law professors argue that federal law enables states to offer tax credits for charitable contributions to state programs in such a way that they could circumvent the SALT deduction cap.

Gamage says when structuring a state-level tax credit such as being discussed in this article, it’s helpful to distinguish between a more aggressive way” and what he calls “a smarter way.”

The aggressive way to structure a plan would be for the state to offer a tax credit for charitable donations to the state’s general fund.

How much might that be?

Well, Gamage says a tax credit of 100 percent would meet the goal of incentivizing state residents, whose federal-level deductions for state-level taxes will be capped, to instead make charitable contributions to the state government. This, in turn, would reduce their state-level taxes.

Since voluntary donations to the state general funds qualify for the federal-level charitable contribution deduction under current law, this plan would allow state residents to effectively transform nondeductible state-level tax payments into fully deductible charitable contribution deductions to the state.

According to Gamage, as with everything, there is also a smarter way. First, the plan would be for a state to offer a less than 100 percent credit for charitable donations to funds set up for specific state programs, with a cap on the total amount creditable per taxpayer.

For instance, states could offer a 90 percent credit for donations made to a fund to support public colleges and universities with the state. The states could then set up multiple funds and residents could choose which programs they want to support.

Why is this plan smarter? Other than everybody likes the idea of choices, a 90 percent (or lower) credit would still enable participants to come out ahead after tax for making a qualifying donation.

Specifically, if a taxpayer in the new 24 percent federal income tax bracket were to make a $100 qualifying charitable contribution through such a program, that taxpayer would save $90 of their state-level taxes and $24 of federal-level taxes. The full after-tax return would thus be $114 of combined tax savings from the $100 contribution.

This sounds pretty good so far, doesn’t it? However, it raises the question as to whether those plans work under federal law. In the sense that existing legal authorities overwhelmingly support them working, the answer is a resounding yes.

Many states already offer credits for charitable contributions of that sort, with the credit amount reaching 100 percent in some cases. The IRS is onboard with low-level guidance. Numerous judicial decisions also support taxpayers’ receiving full federal-level charitable contribution deductions for donations to these programs.

As simple as this seems, more answers are needed to complicated questions. The IRS could justify challenging newly enacted plans, especially for those structured more like the aggressive way than the safe way. But the IRS would face an uphill battle in challenging these plans based on existing legal authorities.

Be sure you are well versed on this and other concerns your clients may have.

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