A clarification on proposed federal regulations targeting state and local tax cap workarounds could breathe more life into state attempts to create more workarounds, according to some tax experts.
“It seems likely that at some point the ‘clarification’ will itself require clarification. Otherwise we’ll be left with a gaping hole in the SALT regulations that taxpayers in red and blue states alike will happily exploit,” said Kirk J. Stark, a professor at the University of California, Los Angeles, School of Law.
This is a view shared among the legal professionals who spoke with Tax Notes regarding the notice issued by the IRS on September 5. The notice was meant to clarify the agency’s proposed regulation issued last month that would shut down attempts by states to circumvent the Tax Cuts and Jobs Act’s (P.L. 115-97) $10,000 cap on SALT deductions.
However, the clarification may have further opened the door it meant to shut.
“If you’re running a business and donate to a state tax credit program, it seems to imply that it is automatically a business expense,” University of Iowa College of Law professor Andy Grewal said. “If that were the case, then you’ve opened up a loophole for individual owners.”
The clarification explained that businesses that make business-related payments to charities or government entities would still be able to deduct the payments as business expenses if they received a state or local tax credit under section 162.
“It creates this deep asymmetry between similar kinds of payments under sections 164 and 170,” UC Davis School of Law professor Darien Shanske said.
The business could give to a charity and take a deduction under section 170, or it could take a business deduction under section 162 assuming it has a sufficient purpose, according to Shanske. “Clearly, for entities that are passthroughs and sole proprietorships, it seems like now you can give a donation at the entity level so long as you have sufficient business purpose,” he said.
Though Shanske said it should create an avenue, he was hesitant to speculate how it might be used by taxpayers.
With Congress discussing the possibility of “tax reform 2.0” ahead of November’s pivotal midterm elections, lawmakers have come under fire from both sides over the unintended effects of the SALT deduction cap. Treasury’s initial approach did not seem to distinguish between programs in red states and blue states, applying the same set of doctrines.
“In that earlier guidance, [Treasury] had rightly chosen to treat programs that have often been created in red states and those newly created in blue states the same,” said NYU School of Law professor David Kamin.
Kamin, who coordinated budget and tax policy for the Obama administration, said the proposed regulations issued last month deserve to be refined, but he agreed with their general direction. “This, by contrast, seems to entirely muddy the waters,” Kamin said of the clarification.
Tax professionals also took issue with language in the notice saying that “the business expense deduction is available to any business taxpayer . . . as long as the payment qualifies as an ordinary and necessary business expense.”
Steven M. Rosenthal of the Urban-Brookings Tax Policy Center gave an example of an individual owning a business as a sole proprietorship that donated money to a private school’s baseball team. If the business donated the money, the amount would be deductible as a business expense, and some states may give a credit for that sort of donation.
But to take that business deduction, the taxpayer would have to claim that they expected it to benefit the business financially, Rosenthal said. He noted that the only financial gain to be had from the donation would be the receipt of the state tax credit, and that alone may not be enough to claim the deduction.
“I think they still would have to establish that the payment was directly related to their business, as well as there’s some meeting of the financial commensurate standard,” Rosenthal said.
Stark said the issue surrounding business expenses isn’t as simple as the IRS statement suggests. “The issue has been the subject of explicit treasury regulations, numerous judicial opinions, and extensive IRS guidance, but the statement made no reference to this legal context,” he said.
Giving money to school choice programs was highlighted as an option by Treasury Secretary Steven Mnuchin in a release following the clarification, saying the recent proposed rule on the SALT deduction cap “has no impact on federal tax benefits for business-related donations to school choice programs.”
“The issue for me is that the IRS’s website just refers to state tax credit programs but Mnuchin’s actual quote refers to school choice programs only,” Grewal said. “That’s what made me confused of what’s really going on here.”
It was also an issue that Kamin questioned, telling Tax Notes that it surprised him that many businesses give to school choice fund programs and are still able to take a business deduction.
“Under the traditional doctrine, an ordinary and necessary business expense must be related to one’s business and not a personal expenditure,” Kamin said, suggesting that some are claiming the benefit is the goodwill associated with giving to a school. But the more likely explanation for him was that the IRS is not going to enforce the ordinary and necessary expense requirement and allow people to deduct through a business expense rather than a charitable deduction. Kamin said if this is the case, he expects states to create programs lauding businesses and giving them tax credits if they donate to special health or education funds.
While not all experts agreed what the clarification means, they all said they expect more clarifications on the issue before final regulations are released. “If this is a harbinger that the final regulations are going to be less principled and a retreat from the proposed regulations, then it’s going to be much weaker as a matter of law,” Shanske said.
Eric Yauch contributed to this article.