Charitable Funds and the Disallowance of Federal Income Tax Deductions for State and Local Taxes
The 2017 Federal Tax Reform Act contains a provision that generally limits the annual income tax deduction for state and local income and property taxes to $10,000. In reaction to this, states and localities have been considering strategies to mitigate that effect, including a work-around in which “voluntary” contributions are made to state and local governments and are credited against state and local taxes in hopes that they would be classified as charitable contributions, rather than payments of taxes.
States and localities have been considering strategies for avoiding the effect of the provision in the recently adopted federal tax reform that generally limits the income tax deduction for state and local income and property taxes to $10,000. One of the approaches that has been suggested is for a state or locality to create a separate fund to which individuals could make voluntary contributions to be used to finance state or local government operations. The donor would get a complete or partial credit against income or property taxes for the contribution. The theory is: the payment would be deductible as a charitable contribution under section 170 of the Internal Revenue Code, even though it would effectively be in lieu of taxes that would otherwise have to be paid. It is well established that a voluntary contribution to a state or local government can be deductible as a charitable contribution. The question is whether a payment to a state or local government that is creditable against a person’s tax liability is a “voluntary” contribution within the meaning of section 170.
A group of economists and academics have drafted a long paper arguing that the charitable contribution/credit mechanism would get around the disallowance of a deduction for state and local taxes. While their analysis is thoughtful, it is not conclusive.
The authors rely on an Internal Revenue Service (IRS) Chief Counsel Advice from 2011 (CCA 201105010) but that is not precedential and does not necessarily state the IRS’s official position. Indeed, the CCA specifically indicates that the IRS did not contemplate issuing published guidance and it acknowledges that there may be circumstances in which a contribution to a state that is creditable against the state income tax may be viewed as a payment of tax and not as a charitable contribution.
I don’t think that anyone, including the authors of the paper, would seriously contend that a direct payment to a state’s general fund for its general purposes that reduced the person’s state income tax liability dollar-for-dollar could be viewed as anything other than an advance payment of tax. It would not be “voluntary” in any sense of the word and it is well established that a contribution to a charity must be voluntary to be deductible. Making the credit less than 100 percent would probably not change the result. Bills using this approach have been introduced in California, New Jersey and Illinois.
The authors of the paper point out that there is a “full deduction rule” under which a charitable contribution is deductible without reduction for state tax benefits that may result from making the contribution. It is well-established that the fact that a voluntary charitable deduction produces tax benefits does not make it less of a voluntary contribution, but that is not the same as saying that a “contribution” to or for the benefit of a government agency that reduces one’s personal income tax liability dollar-for-dollar (or close to that) should be treated as a voluntary contribution. In the latter situation, the taxpayer has paid an amount to finance a state function and would be in exactly the same position as he or she would be in if the amount had been paid as taxes for which the taxpayer would otherwise have been liable.
Would a payment to a special state fund that was used to finance a specific state function that depended on similar contributions for its funding, be viewed as a payment of tax? If a state fund was established to pay the salaries of state legislators and the state made up the difference if contributions to the fund were not sufficient to pay all of the salaries, this would probably be viewed as a payment of tax. Money is fungible and the state is going to spend the same amount of money on the salaries of its legislators regardless of whether part of the money is provided by contributions from the public and the state makes up any deficit in its obligation to the legislators from its general funds.
The technique might work if contributions were made to a special fund for a particular purpose and that purpose was financed entirely by such contributions, or with a contribution from state funds that was equal to a percentage of the contributions received from the public, so that the ability of the state to carry out that function would be limited by the extent to which the public contributed to the special fund. That might work, but this is not what people are talking about. They are talking about using “voluntary” contributions to finance functions that the state would perform regardless of whether it received such contributions and where the state would make up any deficit if the contributions were not sufficient to finance the function. For example, if New York State set up a special fund to finance the creation of a public park in the City of Rochester and the creation of the park was financed entirely by contributions and would not happen if the contributions to the fund were insufficient to pay for the project, contributions to the fund might be viewed as charitable contributions. But if New York State decided to create the park and would make up any deficit in the funds needed to do so if voluntary contributions were insufficient to pay for the project, this would be questionable.
It is true that many programs designed to support private schools and other non-governmental activities that credit contributions against state income tax have received non-precedential IRS approval in private letter rulings, but these situations are different from those in which the “contributions” are made to support essential government functions. This is not the same thing as a program designed to pay the salaries of teachers in the public schools. I have not surveyed all of the programs that have received favorable private letter rulings from the Internal Revenue Service but I suspect that most, and, perhaps, all of them are similar in that they are not used to provide funding for programs that the states would fund in full absent private support. Moreover, the IRS rulings were not issued in the context of a systematic attack by a number of states against a clearly prescribed Congressional policy. The IRS might well take a different view in 2018.
The CCA, as indicated above, is not precedential and it does not discuss the facts presented in any detail. Revenue Ruling 79-315, also cited in the paper, involved an income tax rebate that was not paid in consideration for contributions or any other activity. It simply represented a state tax reduction.
What if contributions were made to a separate 501(c)(3) organization that was required to turn the money over to the state or local government (or that it was understood by all to be expected to do that)? It is likely that the organization would be treated as a conduit, which would be ignored, or as an agent of the state or local government.
There is a real question as to whether the IRS would endorse the contribution credit concept. The few authorities that are out there do not involve a systematic effort by many states to do an end run around a federal policy that is reflected in an unambiguous statute. One can sympathize with the efforts that the states are making to mitigate the effects of the federal disallowance of SALT deductions and, in fact, I have been working with the tax authorities in New York State, New York City and New Jersey on a pro bono basis toward that end. In addition, I am chairing an American Bar Association Tax Section task force that will be providing guidance to state revenue departments and legislatures about responses to the federal tax reform. But the law is what it is and any attempt to mitigate its effects must pass muster under established principles of the common law of taxation, including the well-accepted doctrine that the substance of an arrangement prevails over its form.