In politics, being seen to do something is almost as important as actually doing it. So it was perhaps inevitable that aggrieved blue-state leaders in California, New York, and now New Jersey would push half-baked ideas for thwarting or working around the recent federal tax bill’s “devilish” limitation on state and local tax (SALT) deductions. The SALT limitation will certainly have a negative impact on many blue-state taxpayers, it’s true, but haste and a lack of thoughtful analysis at the national level is no excuse for haste and a lack of thoughtful analysis at the state and local level.
Two main workaround ideas have emerged: first, converting all or part of a state’s personal income tax (not deductible under the new law) to an employer-level wage tax (still deductible); and, second, having taxpayers receive a tax credit for donations they make to state and local government-sponsored charities (still deductible). The first idea is arguably legitimate from a legal point of view, but fiendishly complicated. Which is presumably why leaders like Gov. Murphy and Congressmen Josh Gottheimer (D-5) have called upon the state Legislature to advance the much simpler charity workaround idea. Trouble is, the charity workaround almost certainly won’t work as a matter of law and, more important, shouldn’t work as a matter of public policy. Someone needs to call a flag on this play. Here goes.
How would the charity workaround work? Based on press reports, the plan is to enact state legislation that would authorize the creation of charitable funds to support schools and other local governmental functions that would normally be supported by property taxes. Taxpayer-donors would take a federal charitable deduction and receive a state or local tax credit for the amount of their donation. When the smoke clears, the taxpayer-donor will have paid the same amount out of pocket as before, but will once again benefit from a deduction for the amount she or he “pays” in property tax.
Clever, elegant, even reasonable? Not so fast.
Focusing on the legal issues
Let’s first examine the legal issues. Tax lawyers will cringe at my gross oversimplification, but long-established principles of tax law make it clear that taxpayers can’t deduct donations made without “donative intent” or to the extent that the taxpayer benefits from the donation. See I.R.C. Section 170(c) and IRS Publication 526. In IRS speak: “If you receive or expect to receive a financial or economic benefit as a result of making a contribution to a qualified organization, you can’t deduct the part of the contribution that represents the value of the benefit you receive.” That’s why, for example, donors who buy tickets to a charity dinner need to subtract the value of the dinner from their claimed deduction.
If you think about, this general rule makes sense: if you’re getting something of value in return for your donation, it’s not really a donation, right? Now consider our charity workaround idea. The simple and inescapable truth is that no one would be pushing for this scheme but for the objective of securing a restored tax deduction. Please tell me how a restored tax deduction isn’t “a financial or economic benefit” to the taxpayer-donor.
Although that should be game/set/match, Gov. Phil Murphy and others have assured us that there is “precedent” for the charitable donation scheme. Maybe. It is true that some states provide tax credits in exchange for donations that support various causes or functions such as tuition vouchers, conservation easements, community foundations, or childcare. But my research uncovered only one legal item that speaks to the key issue as to whether donations linked to these credits are in fact tax-deductible: a 2010 IRS Office of Chief Counsel memorandum which concluded that a taxpayer’s receipt of a state tax credit (instead of a deduction) for contributions made to a state agency or a private charitable organization does not negate donative intent. In substance, the memorandum reasoned that, since it is settled law that the expected receipt of a charitable deduction doesn’t defeat donative intent, and thus invalidate a deduction, neither should the expected receipt of a tax credit.
However, the memorandum is easily distinguishable on the facts, was not published as official guidance to taxpayers, and by law “may not be used or cited as precedent.” Moreover, beginning long before the 2017 tax changes, commentators have questioned the memorandum’s legal analysis. Finally, the memorandum itself includes a telling passage – a poison pill, if you will – that highlights the charity workaround’s fundamental weakness: “There may be unusual circumstances in which it would be appropriate to recharacterize a payment of cash or property that was, in form, a charitable contribution as, in substance, a satisfaction of tax liability.” If this isn’t such an unusual circumstance, what is?
Form versus substance
Form versus substance looms large in this discussion. Obviously, a scheme in which tax credits for “donations” to state- or locally controlled charities offset state or local tax liabilities dollar for dollar are deeply suspect. But what if the credit were for less than 100 percent of the donation amount? The lower the credit amount, the easier it might be to argue that the scheme is not, in substance, a simple donation-in-lieu-of-taxes swap. Accordingly, expect our leaders to amend their proposal to lower the credit percentage. Interestingly, a lower credit percentage would effectively allow the state or its localities to share in the tax savings at the federal government’s expense, since the claimed federal deduction would remain the same. How do we think Congress and the IRS will receive that news?
Which brings me to my most important point. Even if the IRS caves under pressure or Congress changes the law to permit this workaround or, better yet, restores the SALT deduction – unlikely, given the stakes for federal revenue – this gimmick shouldn’t work as a matter of public policy.
In practical effect, a tax credit scheme would replace “normal” tax receipts that are distributed pursuant to ordinary governmental budget processes with funds donated (that is, dedicated) for a specific purpose. This raises some tough questions. Despite the growing political allure of “dedicated” taxes in recent decades, is it really such a good idea to move large portions of state or local government spending “off budget”? That might be viable for broad, popular functions like education, but what about controversial stuff such as family-planning services or less sexy functions like maintaining public buildings? Similarly, do we really want to link budget support for core government functions to “voluntary” contributions? How long will it take our enterprising politicians to apply this low-risk approach to ever-more narrow categories of spending? Ironically, legal considerations will support such narrowing: the broader the range of functions supported by contributions, the more the scheme looks like a legally dubious donation-in-lieu-of-taxes swap.
Similar issues arise if donations under the scheme are made to new charities rather than government agencies. Who will control these charities and how will they be held accountable for the way they spend their arguably public funds?
The purpose of taxation is to raise the revenue needed to support necessary government functions and services. In our society, we empower our elected leaders to decide what services (and thus taxes) are necessary, and we hold them accountable through the democratic process. At the core of this idea is the (I hope) uncontroversial notion that government is a collective responsibility and that it is ultimately impractical and undesirable for individual taxpayers to direct their tax dollars to individual priorities. In my view, a charitable donation workaround would upend that notion and invite an unwelcome new era of á la carte government with less accountability to the public. No thanks.