Wait for the Tax surprise this coming April....

Treasury blocks blue state efforts to get around cap on state, local tax deductions

By BRIAN FALER

The Trump administration on Thursday moved to knock down efforts by some blue states to get around a new limit on state and local tax deductions.

The administration says the new rules will prevent people from ducking the $10,000 cap by construing tax payments as charitable contributions, which are not subject to the cap.

The move was immediately denounced by Democrats, and the issue is likely to end up in court.

Lawmakers have been battling over the issue for months, with Democrats like New York Gov. Andrew Cuomo complaining they were unfairly targeted by congressional Republicans to shoulder much of the cost of their recent tax overhaul. Many blue states are highly dependent on taxes paid by the rich, so the new cap threatens a major source of funding for their budgets.

Republicans say the workarounds are little more than gimmicks, and note that most taxpayers are getting a tax cut from the law, even with the cap on the break.

“Congress limited the deduction for state and local taxes that predominantly benefited high-income earners to help pay for major tax cuts for American families,” said Treasury Secretary Steven Mnuchin. “The proposed rule will uphold that limitation by preventing attempts to convert tax payments into charitable contributions.”

Mnuchin also downplayed the risk the new rules posed to similar, preexisting programs run by other states that use tax breaks to help other non-profit causes.

“We believe the proposed rule will have no impact on federal tax benefits for donations to school choice programs for about 99 percent of taxpayers,” he said.

Cuomo denounced the new rules as “politically motivated,” adding: “We will use every tool at our disposal, including litigation, to fight back.”

“In New York, we will not stand for this abuse of government power,” he said. “We are confident that the recently enacted opportunities for charitable contributions to New York State and local governments are consistent with federal law and follow well-established precedent.”

Even if the issue gets tied up in court, the government’s announcement today may be enough to scare many taxpayers from trying to tap the workarounds. Many accountants won’t recommend it to their clients, given the IRS’ stance, because it raises the specter of a major fight with the agency.

Also, people can end up losing money if they try to use the workarounds and are rejected by the IRS.

New York, Connecticut and New Jersey have adopted proposals allowing taxpayers, to varying degrees, to sidestep the SALT cap by recharacterizing their state and local tax payments as charitable contributions, which remain fully deductible. Other blue states like California and Illinois have considered similar moves.

Cuomo and other Democrats have said they are merely restoring what congressional Republicans took from them, but in fact their workarounds actually left their constituents better off than they were before the Tax Cuts and Jobs Act. That’s because taxpayers there would not only be able to effectively claim the same break as before the new law, they will be able to sidestep longstanding federal rules on when exactly the deduction may be taken.

The administration’s new rules target the workarounds by essentially declaring that the IRS will subtract from a taxpayer's federal charitable deduction whatever they get from the state in exchange for their payment.

“For instance, if a state grants a 50 percent credit and the taxpayer contributes $1,000, the allowable charitable contribution may not exceed $500,” the Treasury Department said.

Some Republicans are worried the administration’s efforts to quash the workarounds would hurt other similar — and, in many cases, long-standing — state programs that offered tax breaks for contributions to private charities backed by the government. The new rules include provisions that appear to be designed to shield those programs, though some experts said it was not immediately clear how well they would be protected.

What is clear, said Daniel Rosen, a former IRS lawyer, is that the new rules contradict previous agency edicts — which he said will leave them vulnerable to legal attacks.

“I absolutely expect it to be in court,” said Rosen, now a partner at the law firm Baker McKenzie. “I can guarantee you that there will be challenges.”