David Stewart: Welcome to the podcast. I'm David Stewart, editor in chief of Worldwide Tax Daily. This week: SALT restrictions. One of the most controversial provisions of the TCJA is the new cap on the state and local tax deduction. Since passage of the law, there's been an arms race of local governments trying to find ways around the cap. In August, the IRS issued regulations to shut down those workarounds. Here to walk us through the proposed regulation is Amy Hamilton, chief correspondent for State Tax Notes. Amy, welcome to the podcast.
Amy Hamilton: Thanks for having me.
David Stewart: Why don't we start with some background behind Treasury deciding to focus on these regulations so early in the process.
Amy Hamilton: Sure. If there's one aspect of reform that even nontax people know about, it's probably this. Before, an individual who itemized could claim any state or local taxes paid on their federal return. Then the $10,000 cap was enacted, in part to help pay for federal tax reform. Leaders in blue states called it a form of economic civil war, believing that Republicans had targeted Democratic states. Even before the legislative sessions started, we saw states encouraging taxpayers to prepay their 2018 property taxes, for example, to avoid these new limits. Once in session, several states proposed various ways to get around the cap. The most popular approach by far involved charitable contributions. In May, Treasury and the IRS announced they'd be addressing this type of workaround. And the newly proposed rules make good on that promise.
David Stewart: So, what are these state workarounds that use charitable contributions? How are they supposed to work?
Amy Hamilton: The details vary, but several states have tried to get around the cap by enacting programs to allow individuals to make payments in lieu of taxes to a variety of government-operated public purpose foundations. In theory, individuals could fully deduct that payment as a charitable contribution for federal tax purposes while also satisfying their state and local tax liabilities.
David Stewart: Now, looking at the proposed regulations, how does Treasury and the IRS, how do they plan to shut down these workarounds?
Amy Hamilton: Treasury and the IRS are saying that when a taxpayer receives a state or local tax credit in return for a payment to one of the entities listed in IRC section 170 — that section includes government foundations as well as private charities — they are going to consider the receipt of that tax benefit to be a quid pro quo and that this may preclude a full SALT deduction. I should note that treating a tax benefit as a quid pro quo is different than what people were expecting. Treasury and the IRS in May had suggested they bar such workarounds by using a substance-over-form principle. Under the proposed rules, a taxpayer making payments to one of these eligible entities would be required to reduce their federal charitable deduction by the amount of any state or local tax credit they received for that donation. Exceptions are provided for dollar-for-dollar state tax deductions and for tax credits of no more than 15 percent of the payment amount, or for the fair market value of the property transferred.
David Stewart: Now, I don't know much about these state charitable programs, but would this affect other preexisting programs?
Amy Hamilton: It sure would. The day the guidance was issued, Ways and Means Committee Chair Kevin Brady said that the approach would close the door on “improper tax evasion schemes,” these plans developed by the states to circumvent SALT cap. But he also said that the proposed rules would preserve existing state charitable tax credit programs.
Treasury Secretary Mnuchin went further by mentioning preexisting school choice programs in particular. He said Treasury believes the proposed rules would have no impact on federal tax benefits for donations to school choice programs for about 99 percent of taxpayers compared to prior law. But when practitioners had 24 hours to look over the guidance, the consensus was that at the very least, the proposed rules would shut down preexisting mechanisms allowing taxpayers to turn a profit off of charitable donations to private schools. But there are tax credit scholarship programs in 18 states — mostly red states — that predate the TCJA, and people who represent scholarship granting organizations said the impact goes even further. One practitioner said Treasury and the IRS apparently view these legitimate existing programs as mere collateral damage, and the debate is far from over.
David Stewart: Now, I understand the IRS and Treasury have issued a clarification, but it only seems to have confused matters?
Amy Hamilton: That's right, and the clarification itself was short. The $10,000 cap applies to individuals only. State and local taxes paid or accrued in carrying on a trade or a business, those are still fully deductible at the federal level. And I should mention that this difference is at the core of other state workarounds that Treasury and the IRS are not addressing in this guidance yet. In any event, in the clarification, which Treasury and the IRS said was in response to taxpayer inquiries, a business taxpayer making a payment to a charitable or government entity described in section 170 would generally be allowed to deduct the entire payment as an ordinary and necessary business expense, if that payment is made with a business purpose. Passthrough entities and sole proprietorships then seemingly could give to a charity and take a deduction either under IRC section 170 or as a business expense under IRC section 162, as long as they have a sufficient business purpose. Law professor Kirk Stark said the clarification itself will likely need to be clarified. Otherwise, we're going to be left with a gaping hole in the SALT deduction regulations, and taxpayers in both red and blue states alike will be happy to exploit that.
David Stewart: So, there's a very heavy political aspect to it. So what are the politics of the SALT cap going forward?
Amy Hamilton: Already this summer, we saw New York, New Jersey, Connecticut, and Maryland join in a lawsuit against the IRS. They're challenging the constitutionality of the SALT cap itself. New Jersey's attorney general now is threatening to sue over the proposed regulations. And he's reportedly drafting comments to submit to Treasury and the IRS about them. Within two weeks of their proposal, those proposed rules had already received more than 100 comments, by the way, which isn't unusual in regard to controversial topics. Also, New York Governor Cuomo has asked Treasury's inspector general for tax administration to investigate whether partisan politics played a role in these newly proposed rules.
David Stewart: Since these are proposed rules, I take it we're in the comment period and that there is a hearing coming up. When are those deadlines?
Amy Hamilton: Sure, comments are due October 11, and IRS has scheduled a November 5 public hearing.
David Stewart: Well, we'll definitely check in with you later on when these are finalized. Thank you for being here.
Amy Hamilton: Thank you so much.
David Stewart: And now, Coming Attractions. Each week we do preview commentary that will be appearing in the next issue of the Tax Notes magazines. We are joined by executive editor for commentary, Jasper Smith. Jasper, what will you have for us?
Jasper Smith: In Tax Notes, practitioners from Ropes & Gray describe how tax-exempt organizations with endowment assets can apply Notice 2018-67, issued in August, to help taxpayers aggregate their activities under unrelated business taxable income. Also, Libin Zhang and Michael Grisolia discuss issues involving earnings and profits from real estate investment trusts, specifically when it doesn’t reflect taxable income to the REIT.
In State Tax Notes, Timothy Noonan and Ariele Doolittle review and interpret the New York State Division of Tax Appeals annual report to the governor and State Legislature. Also, Michelle DeLappe explores several timely issues related to special benefit assessments, and reviews recent court decisions.
And in Tax Notes International, Tatiana Falcão discusses overseas development assistance, connecting it with the international tax framework and double tax treaties. Additionally, practitioners from Eversheds Sutherland discuss the effect of international tax reform on Form 1099 reporting and potential problems for taxpayers.
David Stewart: You can read all that and a lot more in the October 8th editions of Tax Notes, State Tax Notes, and Tax Notes International. That's it for this week. You can follow me on Twitter @TaxStew, that's S-T-E-W. If you have any comments, questions, or suggestions for a future episode, you can email us at podcast@taxanalysts.org. Be sure to subscribe to us on iTunes or Google Play to make sure you get the next episode of Tax Notes Talk.
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