- Tax Cuts and Jobs Act capped the state and local income tax (SALT) deduction at $10,000
- New York State passed two workarounds
- IRS implies the charitable funds workaround may not be ‘charity’ for federal tax purposes
- Future IRS opinions may create collateral damage
At this point, we’ve all heard of the Tax Cuts and Jobs Act (aka the new tax law) and its $10,000 cap on our state and local income taxes. We’ve lamented the loss of our deductions and discussed it at networking events, cocktail parties, and just about everywhere else. But, there’s nothing that can be done about it, right? Well, sorta…
In the immediate aftermath, New York State promised a workaround. Initially, Governor Cuomo signed executive order 172 which included some choice words (seriously, check it out) and allowed all New Yorkers to prepay their entire 2018 property tax bill in 2017. For many, the state and local income tax cap conversation ended there.
However, New York State kept working on more permanent workarounds, some of which made minor headlines in January. About a month ago, the New York legislature delivered on their promises with two workarounds, included in the budget bill, which I’m going to grossly oversimplify:
New York State will create two charitable funds, one for healthcare and one for education. If you contribute to one of the funds, you will receive a tax credit (a dollar for dollar reduction in taxes) based on your contribution. Municipalities can also create their own charitable funds and give property tax credits in exchange for donations. In theory, you will also be able to deduct these contributions as charitable deductions on your federal tax return.
Employers will be able to pay an optional, fully deductible payroll tax. Employees of these employers would then receive a tax credit (again, a dollar for dollar reduction in taxes) to negate the expected pay cuts. In theory, this will shift some of the New York State income tax paid by employees to employers.
These workarounds didn’t come without their criticisms. Some have noted that the payroll tax effectively requires employees to take a pay cut, which may be impossible due to unions, contracts, and emotional resistance. Even if that could be overcome, others have pointed out how difficult this would be to enact for larger, multi-state employers and that this workaround may only benefit smaller businesses with highly compensated employees.
The charitable funds workaround has drawn much harsher criticism. Many do not believe the donations are actually charitable because of the obvious personal financial gains. Treasury Secretary Steven Mnuchin said, “It’s one of the more ridiculous comments to think that you can take a real estate tax that you’re required to make, and dress that up as a charitable contribution,” back in January when the idea was first suggested.
IRS Notice 2018-54
Now that the backstory is out of the way, what exactly is IRS Notice 2018-54? Well, an IRS notice typically provides official guidance and interpretations in situations where it was missing but, this notice didn’t actually say much of anything. It mainly promised future guidance. However, if you read between the lines, the IRS isn’t a fan of the charitable funds workaround that New York and several other states are implementing.
The most interesting (and understandable) passage reads:
Despite these state efforts to circumvent the new statutory limitation on state and local tax deductions, taxpayers should be mindful that federal law controls the proper characterization of payments for federal income tax purposes.
Meaning, federal law decides what is and is not a deductible charitable contribution on your federal tax return. Just because New York calls their funds charitable, does not make them so.
The notice goes on to mention ‘substance-over-form’ or the idea that the true economic purpose/reason for a transaction signals its true intent, regardless of any legal wordplay. In this case, the IRS is implying that they think the true economic purpose of the charitable donations is for personal benefit and not charity for the sake of charity, as the law implies.
Lastly, in a news release related to Notice 2018-54, the IRS goes on to say:
Taxpayers should also be aware the U.S. Department of the Treasury and the Internal Revenue Service are continuing to monitor other legislative proposals being considered to ensure that federal law controls the characterization of deductions for federal income tax filings.
This reiterates their point that federal law gets the final say on what is or is not charitable. But, unlike the Notice, it also mentions that the Treasury and IRS are actively monitoring these new State laws.
Almost eight years ago, there was a similar situation. A State wanted to fund a program with charitable contributions and give a tax credit in exchange for donations. The IRS issued Chief Counsel Advice concluding that these contributions were charitable.
Technically, Chief Counsel Advice isn’t supposed to be cited as precedent for anything else and it even says as much in the memo. But, in the years since, other States have created similarly funded programs based on the same Advice.
The unanswered question is, will the IRS’s future guidance on the new charitable fund workarounds also destroy the previous Chief Counsel Advice which many States rely on to protect their programs?
What Does This Mean for You?
Consider holding off on any donations to New York’s (or your municipality’s) charitable funds until after the IRS has issued further guidance because the charitable nature of these payments is a crucial aspect of this workaround. Some very conservative accountants have even suggested waiting until after this issue is settled in court.
That said, this isn’t all bad news. The IRS hasn’t issued their official opinion on the charitable funds and, at the moment, the optional payroll tax still stands. So, there’s still hope for Long Island taxpayers.
Image from Matt Wade: CC-BY-SA-3.0/Matt H. Wade at Wikipedia