The IRS on Wednesday put taxpayers on notice that at least one type of workaround to offset the new $10,000 limit on state and local tax deductions will likely not pass muster.
“Taxpayers should be mindful that federal law controls the proper characterization of payments for federal income tax purposes,” IRS said in its guidance. The agency was referring to state programs or proposals that let taxpayers characterize payments for state and local government services as charitable contributions rather than taxes.
Under those schemes, taxpayers pay into funds controlled by state or local governments for purposes of paying state and local taxes and receive state tax credits as well as a federal tax deduction, as if those payments were a charitable contribution.
To date, New York state and New Jersey have both signed into law such programs. The New York state law also uses another type of workaround that essentially shifts some employee payroll taxes to employers if the employer volunteers for the program. The employers can deduct the additional payroll taxes, and the employees would receive a tax credit equivalent to the value of that deduction.
In its latest notice, the IRS said it intends to propose regulations on these tax workarounds which would “assist taxpayers in understanding the relationship between the federal charitable contribution deduction and the new statutory limitation on the deduction in state and local tax payments,” which was capped at $10,000 in the recent tax overhaul legislation. That ceiling is what has prompted some high-tax states like New York and New Jersey to develop programs to essentially lift the $10,000 ceiling in other ways.
The IRS did not offer any time frame for when it intends to propose new regulations, but it’s not expected to be soon. Otherwise the agency would have just proposed new rules rather than issue guidance that it plans to do so, says Howard Gleckman, senior fellow in the Urban-Brookings Tax Policy Center at the Urban Institute.
“It will take a while and in the interim the IRS is providing informal notice, a warning to the states that it will likely find problems with these programs.”
Gleckman found it interesting that the IRS only warned about the charitable deduction scheme and not the one involving payroll taxes.
Jared Walczak, senior policy analyst at the conservative-leaning Tax Foundation, welcomed the IRS guidance. “As we have made clear in our research, state workarounds are legally dubious and make the tax code more complex and regressive … Formal IRS guidance will help ensure that taxpayers do not face penalties or higher overall tax liability from relying on questionable state guidance.”
Until there is formal guidance from the IRS, taxpayers should follow existing federal law, says Megan Gorman, a founding partner of Chequers Financial Management in San Francisco. “Let this play out.”
Gorman notes that while some states are very focused on workarounds to address the new, lower state and local tax deduction limit, many have not yet addressed other issues created by the new tax law. California, for example, hasn’t made any decision on what changes in the federal tax law it will piggyback on. It hasn’t decided whether to allow deductions for contributions to 529 plans that are used to pay for private primary and secondary schools, as the new tax law allows.
Meanwhile, Gov. Andrew Cuomo of New York pledged in a statement to continue the fight against the $10,000 limit on state and local tax deductions, which targets New York and other Democratic states.
“The IRS should not be used as a political weapon,” he said, “and I urge this administration to stop its partisan assault on New Yorkers and instead work with us to deliver real, lasting relief for hardworking families.”