To the People of the States of New York, Connecticut, Oregon, New Jersey, et al.:
IT HAS been already observed that the federal government ought to possess the power of providing for the support of the national forces; in which proposition was intended to be included the expense of raising troops, of building and equipping fleets, and all other expenses in any wise connected with military arrangements and operations. But these are not the only objects to which the jurisdiction of the Union, in respect to revenue, must necessarily be empowered to extend. It must embrace a provision for the support of the national civil list; for the payment of the national debts contracted, or that may be contracted; and, in general, for all those matters which will call for disbursements out of the national treasury. The conclusion is, that there must be interwoven, in the frame of the government, a general power of taxation, in one shape or another. [The Federalist No. 30.]
Your legislators’ plans to redesignate taxes paid into your state fisc as charity are problematic attempts to encroach on the federal taxing power. Further, separating state spending from taxpayers who pay for that spending diminishes the sovereignty of the states.
Federalist No. 30 goes on to say that money is, with propriety, what enables the body politic to perform its most essential functions. The federal government’s taxing power, established in the spending clause and later the 16th Amendment, is therefore broad. Article I, section 8, clause 1 of the Constitution says Congress has the power to tax “to pay the Debts and provide for the common Defense and general Welfare of the United States.”
The Tax Cuts and Jobs Act (P.L. 115-97) put a long overdue limitation on the state and local tax deduction. The charitable deduction schemes merely add absurd mechanics to what is fundamentally a constitutional problem, which the federal government must fix.
One piece that is missing from many of the discussions about workarounds is that offsetting state expenses through the federal tax code undermines state sovereignty even though it provides some additional money for state projects. There’s no requirement that the federal government give taxpayers a deduction for the state and local taxes they pay. The Supreme Court explained in White v. United States, 305 U.S. 281 (1938), that deductions are “a matter of legislative grace, and only as there is clear provision therefor can any particular deduction be allowed.” Congress recognized this when it added a $10,000 limitation on individual deductions of state and local taxes to section 164(b)(6) in the TCJA, effectively limiting the federal subsidy on state government. Furor has resulted over the change because it will significantly affect state budgets. As the Institute on Taxation and Economic Policy has pointed out, “On average, a fifth of all state personal income and individually-paid property taxes are shifted to the federal government (and to taxpayers nationwide) as a result of the deductibility of state and local taxes from the federal tax.”
Money enables charitable organizations to respond to local needs. Encouraging private — but not profit-driven — enterprise in community-building was, at least in part, why Congress decided more than 100 years ago to exempt some charitable organizations from taxation. Congress then decided to allow a deduction for donations of cash and property made to those organizations, and later added gifts given to domestic governments at various levels exclusively for public purposes.
The state laws that would allow taxpayers to receive a state tax credit for payments into state-run funds that use the money for governmental actions and seek to label those payments “charitable” for federal tax purposes are an attempt to circumvent Congress’s clear intent in enacting the limitation on the deductibility of state and local taxes in section 164(b)(6). States can’t transform themselves into charitable organizations through the use of their sovereign powers and shouldn’t try to do so. The basis for the tax treatment of charities and charitable donations is to encourage private engagement in the community. One important reason for that is to protect against the risk of government overreach. State circumvention would therefore violate the fundamental purpose of the federal charitable deduction.
Will the Charitable Deduction Plans Succeed?
States think these plans might work because the IRS, citing court decisions, maintains in memos like ILM 201105010 that “the tax benefit of a federal or state charitable contribution deduction is not regarded as a return benefit that negates charitable intent, reducing or eliminating the deduction itself.” The IRS memo concludes that there’s no essential distinction between a state tax deduction and a state tax credit. The general treatment of a state or local tax benefit as a reduction or potential reduction in tax liability for federal tax purposes and not as consideration that might constitute a quid pro quo is the premise of the new state laws. However, in the same memo, the IRS explains that “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.” Those unusual circumstances are present when a state attempts to subvert federal tax law.
A critical aspect of ILM 201105010 is that the payments at issue were made to state agencies or to charitable organizations. What must be clarified in the law — and what neither the IRS memo nor the opinions it cites address in any detail — is that a government actor that possesses the power of the state isn’t a charity by definition and therefore cannot be the recipient of a charitable contribution under section 170(c)(2). There’s a fundamental difference between the state appropriating money and its residents giving it discretionary financial support beyond the required taxes, as the deduction for gifts to governments in section 170(c)(1) implicitly acknowledges. The key concepts in subsection (c)(1) are “gift” and “public purposes,” both of which would be distorted if a taxpayer could receive a deduction for payments credited at the state level. Taxes aren’t gifts in any reasonable sense of the word, and the public purpose of the state law schemes is to extract a federal subsidy for the state purse.
In addition, the fundamental difference between a charity that is “organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes” under section 501(c)(3) and a state agency that, for example, provides public education is that charities lack the sovereign power to compel action. States have that power. Accordingly, there are checks on the exercise of state power that are unnecessary for charitable organizations.
The states’ plans to circumvent the TCJA’s SALT deduction limitations are predicated on the mistaken assumption that performing a government function, such as providing education or healthcare services, is sufficient to bring an entity within the ambit of charity. However, the charitable contribution laws plainly aren’t meant to cover every government function, broadly construed. They’re meant to encourage private citizens to serve their communities, especially through actions that they might not otherwise perform. But the federal government can respond to these attempts to encroach on its taxing power and restore a small but significant piece of the states’ sovereignty as well. To the extent the law is unclear about the basic purpose of the charitable deduction, Treasury and perhaps Congress should amend it to make it clear.
Although Congress could help block the attempted end-runs simply by making it clear in section 170(c)(2) that only donations that ultimately wind up outside state treasuries can be charitable contributions, a statutory change is technically unnecessary because Treasury has the authority to verify deductions for charitable contributions and so should be able to exclude tax payments. The IRS warned in Notice 2018-54, 2018-24 IRB 750, that it wouldn’t sit idly by while state legislators enact their proposals: “Taxpayers should be mindful that federal law controls the proper characterization of payments for federal income tax purposes.” State laws, however cleverly constructed, cannot re-engineer federal law. And making a technical argument based on informal guidance is particularly risky.
Democratic Objections
The undemocratic passing along of a portion of the cost of state and local government to other states was relatively transparent in the SALT deduction. It is much less transparent for charitable donation deductions in which the payments go to and remain in state entities. But the opaqueness makes the charitable deduction plans even more of a subversion of basic democratic principles than the SALT deduction.
The charitable donation deduction is available to both public and private organizations, but that shouldn’t be taken as an indication that Congress approves of calling tax dollars paid to a state or local government charity for federal tax purposes. The deduction allowed for gifts made to the State University of New York, for example, is equally available to gifts made to the University of Florida or the University of Iowa. The residents of all the states, through their representatives in Congress, have signed off on supporting state-run universities through the deduction. Florida and Iowa residents have not, however, signed off on unlimited support for the state government of New York and others, or even unlimited support for primary and secondary public education in New York. Universities are arguably different because attendance is optional.
To be sure, Florida and Iowa residents, through their representatives in Congress, have agreed to defray the expenses of the government of New York and other states up to the $10,000-per-taxpayer limit. Before the TCJA, they evidently approved of an even greater level of support. But the statutory change can only reasonably be read as an affirmative statement by Congress that high-tax states may have limited general support.
There’s also a difference between the proposals to call donations to funds that are essentially fungible with general state revenues charitable contributions and a state legislature deciding to grant deductions for contributions made to non-state charitable organizations, as in Arizona Christian School Tuition Organization v. Winn, 563 U.S. 125 (2011). In that case, the school tuition organizations were private entities, and the money donated ended up going to private schools, not the state treasury. The organizations lacked the state’s power of compulsion, which should be a material difference for the charitable deduction. If the state’s residents dislike a charity legislators have deemed deserving of support, they may register their objection in a later election. But when a state attempts to supplement its state budget through the federal tax system, there is no check. The state’s revenue is subsidized by out-of-state residents who have no way of holding that state’s legislators accountable.
There’s a distinction between South Carolina offering a tax credit for donations to a publicly administered fund that pays tuition for students at private schools and New York offering a tax credit for donations to pay education expenses the state itself incurs in running its public schools. New York proposes to have the trustees of its charitable funds for education transfer the money given to the funds to the general funds of public school districts. The difference between the private school recipients in South Carolina and public school recipients in New York is one that Congress and Treasury may appropriately treat differently in the tax law because the government acting through its schools possesses the power of the state. That power isn’t held by the private schools. Further, South Carolinians can use the ballot box to change their state’s spending decisions, but non-New York residents who object to New York’s plan to continue to have the federal government subsidize its state spending choices have no such recourse.
The objection that the tax credit offered in South Carolina is a dollar-for-dollar credit, which means that South Carolina taxpayers can wipe out the cost of the donation through state tax benefits and then reap the benefits of a federal charitable deduction for the same donation, is valid. State tax credits or deductions aren’t factored in when accounting for charitable donations on a taxpayer’s federal return. Congress, and probably Treasury through regulations, could and should halt this double dipping. But even if they don’t, that decision doesn’t justify converting payments made to a state entity to fund governmental activity. Allowing taxpayers who itemize to take the charitable contribution deduction and any state tax benefits for their donations isn’t meant to allow turning state tax payments into charitable contributions, but to encourage charitable donations, minimize administrative burden, and subsidize charitable organizations without having to appropriate money to them.
History of the Deduction for Gifts to States
The history of the charitable deduction and the treatment of charitable endeavors more broadly shows that payments made to state actors exercising their sovereign authority have never been considered charity. In the early days of the United States, lawmakers argued about whether spending requests for local projects had sufficiently national implications, and the bar for federal financial support was high.
The Tariff Act of 1894 was the first U.S. statute to include an exemption from the 2 percent tax on net profits or income for “corporations, companies, or associations organized and conducted solely for charitable, religious, or educational purposes.” In the same paragraph as the charitable exemption, Congress exempted states, counties, and municipalities from the 2 percent tax, but these are two separate exemptions. The Supreme Court declared the income tax in the 1894 law unconstitutional, but the language Congress used in exempting charitable, religious, and educational organizations became the basis for later versions of the law regarding the tax treatment of charity.
The Revenue Act of 1917, in addition to the deduction for state and local taxes paid, allowed a deduction for contributions made within the year to “corporations or associations organized and operated exclusively for religious, charitable, scientific, or educational purposes, or to Societies for the prevention of cruelty to children or animals, no part of the net income of which inures to the benefit of any private stockholder or individual, to an amount not in excess of fifteen per centum of the taxpayer’s taxable net income.” Congress instructed Treasury and the IRS to write rules governing the process of verifying contributions.
In 1921 Congress added the relevant language allowing a deduction for contributions or gifts to state and local governments “for exclusively public purposes.” An economic depression followed the end of World War I, and income tax rates that sharply increased during the war were substantially lowered in the 1921 law, two factors that may have been at play in the addition of a deduction for gifts made to the government.
Notably, the early versions of the addition didn’t define a contribution or gift to a government as a charitable contribution, but merely as a contribution or gift eligible for a deduction. The title “Charitable and Other Contributions” that was added to the section in 1928 further indicated a distinction between charitable and other deductible payments. In the 1954 code, the deduction was recodified as section 170(c) and defined contributions to state and local governments as “charitable contributions,” but this change was a drafting convenience and not an endorsement of the idea that gifts to governments are charity. Section 170(c)(1) has remained essentially unchanged since 1954.
Spending Clause Considerations
The Founding Fathers debated the scope of the “general” welfare in the spending clause, with the prevailing view that only spending on items that would benefit the entire nation was permissible under that clause. Determining what types of things fit into “national” and “local” categories was relatively easy in the days of the horse and buggy.
The technological shift of the past 229 years has made it much more likely that any given project will have an impact on the general welfare. That matters because finding the proper balance between national and local government remains as important today as it was over 200 years ago, but ideologically neutral technological change leans toward consolidating power in the national government. That it’s now much harder to find a purely local government expense means that preserving the states’ sovereignty is even more difficult. The appropriate response isn’t, however, to shoehorn state spending into the federal charitable donation deduction. Although some of the existing schemes to subsidize state and local government projects through the federal charitable deduction, and even the new schemes designed to thwart the TCJA, look like a positive expression of state sovereignty, they aren’t. Taking state sovereignty seriously requires that we prevent the states from enlisting the residents of other states to carry the burden of their state expenditures through the federal tax system.
States might not want to set the precedent of undermining the federal government’s taxing authority this way for two reasons. First, the taxing power of Congress is now so broad that when the Supreme Court decided that the commerce clause crumbled under the weight of the Affordable Care Act, Chief Justice John G. Roberts Jr. invoked the taxing power to save the statute (National Federation of Independent Business v. Sebelius, 132 S. Ct. 2566 (2012)). Should state governments succeed in limiting the taxing power through these workarounds, particularly when its use is as clearly expressed as it is in the TCJA, the possibility of Congress using the spending clause to enact new legislation should be much more constrained than it is now. Further, a diluted taxing power would suggest that states should also be able to limit the use of far more weakly prescribed powers such as the power to regulate commerce.
Second, it’s unwise for states to try to circumvent federal taxing authority in this manner because of the message it sends about the value of taxpaying and adhering to the clear intent of the law. The federal government has a difficult job in correcting the charitable contribution policy, but the states leave it with little choice.