By Manoj Viswanathan, Associate Professor of Law, UC Hastings College of the Law
The current version of the GOP tax bill dramatically limits the deductibility of state and local taxes. For individuals, the deduction for state and local income taxes is eliminated entirely and the deduction for state and local property taxes is limited to the first $10,000. [fn.1] Though much has been said about the proposal, there has been little discussion about how eliminating the state and local tax deduction dramatically incentivizes (1) states to solicit charitable contributions in exchange for state tax credits and (2) taxpayers to make these charitable contributions.
Consider a taxpayer donating $500 to a tax-exempt private school in Arizona. Assuming the taxpayer itemizes, this reduces the taxpayer’s federal taxable income by $500 as per Sections 170(c) and 67(b)(4). Under Arizona’s School Tax Credits for Individuals program, this donation also entitles the taxpayer to a dollar-for-dollar $500 credit against state income tax liability. By donating the $500, the taxpayer has both saved $500 in state tax liability and obtained a federal charitable contribution deduction of $500.
Although the $500 state tax credit feels like a quid pro quo that should correspondingly reduce the deductible portion of the federal charitable contribution deduction, I.R.S. and Tax Court authority indicate otherwise. [fn.2] As described in detail by Phillip Blackman and Kirk Stark in 2013, state tax credits received in conjunction with a charitable contribution to the state are generally viewed as a reduction in liability owed to the state rather than a deemed payment of state taxes. As a result, no quid pro quo reduction of the federal charitable contribution is required.
This ability to “double-dip” and obtain both state/local and federal tax benefits from a single charitable contribution is, under current (i.e., pre-GOP tax bill) law, undercut by the deductibility of state and local taxes. For each additional dollar contributed to the Arizona school, Arizona income taxes owed are commensurately reduced, thereby reducing the state and local tax deduction. The charitable contribution deduction goes up, but the state and local tax deduction goes down. The Arizona taxpayer described above has the same taxable income if she donates the $500 or not because the charitable contribution deduction and the deduction for state and local taxes are both below-the-line, itemized deductions.
As a result, under current, pre-GOP tax bill law the only taxpayers able to double-dip are filers precluded from taking the state and local tax deduction, such as taxpayers subject to the alternative minimum tax. An AMT filer otherwise unable to enjoy the deduction for state and local taxes would benefit from converting state and local tax payments to charitable contributions since the latter may still be deducted by AMT filers. Indeed, as reported by the New York Times, states have promoted these tax credit programs to raise funds for private schools, even though the number of AMT filers is relatively small, approximately five percent of all filers.
But given that the tax bill severely curtails the state and local deduction for most if not all individuals, many more taxpayers could take advantage of state-level initiatives that essentially reclassify state and local tax payments as federal charitable contributions. States where taxpayers are especially affected by the elimination of the state and local tax deduction (such as Maryland, Connecticut, and New Jersey) are especially motivated to promulgate such state tax credit initiatives.
Note that an individual need not be an itemizer prior to making the charitable contribution deduction in order to benefit. Consider a single taxpayer with a federal marginal income tax rate of twenty-eight percent with $150,000 of taxable income. Let’s assume she pays $10,000 in state income taxes and $6,200 in local property taxes. Under the tax bill this taxpayer would take the $12,200 standard deduction since she has only $6,200 in itemized deductions (the first $10,000 of property taxes remain deductible). But if the state issued a dollar-for-dollar state tax credit for charitable contributions made to, say, the state’s general infrastructure fund, the first $6,000 donated, though reducing state tax liability by $6,000, does nothing to lower federal taxes owed because the taxpayer would still take the standard deduction. But each additional dollar contributed beyond the $6,000 saves the taxpayer $1.28—one dollar in state tax liability, and twenty-eight cents from the federal charitable contribution deduction now obtained by itemizing. [fn.3] As a result, this taxpayer previously taking the standard deduction but now itemizing could donate $10,000 to the state infrastructure program and save at least $11,120–$10,000 in state taxes and $1,120 in federal. [fn.4]
Although the preceding example uses a dollar-for-dollar state tax credit, even a less generous state tax credit would create the distortion I describe. Assuming that each dollar contributed reduces federal taxable income, and that a reduction in federal taxable income correspondingly decreases state taxable income, we can determine the minimum credit percentage states should offer to incentivize participants as a function of the federal and state marginal tax rates. [fn.5] For federal and state marginal tax rates of twenty-eight and ten percent, respectively, the necessary credit need only be 69.2 percent. That the tax bill expands the charitable contribution limit to sixty (from fifty) percent of AGI gives taxpayers additional leeway to make the necessary charitable contributions.
The I.R.S. and/or Congress could combat this technique in many different ways. For instance, the I.R.S. could deem a substantial state tax benefit received in exchange for a charitable contribution to be a deduction-reducing quid pro quo. Or, the charitable contribution deduction could be restricted or further limited via an even larger standard deduction. Lastly, and perhaps most simply, the state and local tax deduction could be preserved. Regardless of the approach taken, I agree with Blackman and Stark in that the ability of a state to capture federal tax dollars via creative state tax credit initiatives is almost certainly bad tax policy when viewed from the national perspective. But this will not stop states (and taxpayers) from trying.
[fn.1] Although ambiguous on whether investors and individuals receiving income through pass-throughs retain the state and local income tax deduction (see David Kamin’s recent posts here, here, and here) employees earning labor income are unconditionally precluded from taking the deduction.
UPDATE: Kevin Brady, Chairman of the Ways and Means committee, has issued a letter indicating that individual owners of pass-through businesses will not be able to take a deduction for state and local income taxes on their individual returns.
[fn.2] See generally Chief Counsel Advice 201105010 (Feb. 4, 2011); Tempel v. C.I.R., 136 T.C. 341 (2011); Virginia Route 231, LLC v. C.I.R., 107 T.C.M. 1155 (T.C. 2014).
[fn.3] Since the starting point for many state income tax calculations is either federal adjusted gross income or federal taxable income, a dollar-for-dollar tax credit might lose the state revenue.
[fn.4] Since the taxpayer only had $6,200 of itemized deductions prior to making the $10,000 charitable contribution, federal taxable income is only reduced by $4,000 of the contribution (assuming a standard deduction of $12,200). This $4,000 reduction is worth (28%)($4,000) = $1,120. Note this understates the potential state tax savings since federal charitable contribution deductions often also reduce state income tax liability.
[fn.5] If f and s and are the federal and state marginal income tax rates, respectively, the state credit percentage should be at least 1 – f – (f)(s).