State and local income tax - notebook (Image: Shutterstock)

If you or any of your clients were hoping for a legal way to get around the relatively new federal $10,000 limit on state and local tax (SALT) deductions, forget about it.

The IRS has just issued final regulations on charitable contributions and state and local tax credits that essentially nix the most popular idea behind such workarounds: recharacterizing most of the state and local taxes as a charitable contribution to a specific fund that would then qualify for a federal tax deduction and state tax credit.

“The regulations prevent charitable contributions made in exchange for state tax credits from circumventing the new limitation on state and local tax deductions,” according to a statement from the U.S. Treasury.

As a result of the 2017 tax cut legislation, the federal government capped the deduction for state and local taxes at $10,000, which affected residents, especially homeowners, in high-tax states like New York and New Jersey. Both states subsequently passed laws that allowed the charitable contribution workaround, though New Jersey required that local governments create the charitable funds. Now those workarounds are essentially dead.

Under the final IRS regs, a taxpayer contributing to a fund able to receive tax-deductible contributions after August 27, 2018, must reduce their federal charitable contribution by the state tax credit received.

The IRS, in its new final regulation, gives the example of a taxpayer contributing $1,000 to a state tax-deductible fund that grants a 70% state tax credit for the contribution, worth $700. That taxpayer would then have to reduce the federal charitable deduction by $700, leaving only a $300 federal tax deduction. No reduction in the federal deduction is required if the state tax credit is set at 15% or less.

A more relevant example for those living in high-tax states would be a taxpayer owing $20,000 in state and local taxes who pays $10,000 into a state charitable fund to make up for the SALT deduction limit. If the taxpayer receives a $9,000 tax credit for that contribution, she would only be entitled to a $1,000 federal tax deduction.

“This is an application of the quid pro quo doctrine,” writes Jared Walczak, a senior policy analyst at with the Center for State Tax Policy at the Tax Foundation, in his analysis of the IRS ruling. “If you expect to receive a benefit from a contribution, then it is not truly charitable.” He tells ThinkAdvisor that a taxpayer contributing to such a workaround fund “could end up paying more in taxes and potentially face a penalty.”

The IRS’ ruling finalizes what it had proposed last summer. It isn’t surprising but is disappointing to those who favored the workarounds.

New York Governor Andrew Cuomo, in a statement, said the ruling continues the federal government’s “politically motivated economic assault on New York,” and said his administration “will pursue all options, including litigation, to resist this attack on our state and our taxpayers.”

New Jersey Governor Phil Murphy called it “a gut-punch to middle-class families who know that the Trump tax plan is a complete sham” and pledged to continue to fight to restore New Jersey residents’ full SALT deductions.

Frank Sammartino, a senior fellow at the Urban-Brookings Tax Policy Center, said the IRS ruling “may cause states to rethink their tax systems, relying less on property taxes and more on payroll or business taxes, depending on how progressive they want their taxes to be.”

Other lower tax states, such as Alabama, Arizona, Georgia and South Carolina, will also be affected by the new IRS rule. Those states have programs providing 100% tax credits for donations to support K-12 private schools — donations that taxpayers claimed as a federal deduction even before the 2017 tax cut legislation took effect but used since by some as a workaround for the SALT deduction limit. Now those taxpayers, too, won’t be able to claim any federal tax deduction.

“It’s interesting that those ‘tax shelters’ weren’t addressed until the blue states tried to use the same argument,” said Megan Gorman, the founding partner of Chequers Financial Management.

In Washington, the House Ways and Means Committee will be holding a hearing in late June to discuss “the impact of the SALT deduction cap on communities and possible next steps,” said a committee spokeswoman. Senate Finance Committee Chairman Chuck Grassley, however, has already said he isn’t interested in considering any changes to the current law.

— Related on ThinkAdvisor: