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May 29, 2018

IRS Responds to State Tax Deduction Workarounds (article)

SALT WorkaroundsState legislatures have reacted to the new $10,000 limit on the federal deduction for state and local taxes (SALT) with workaround legislation. States intend to ensure that taxpayers won't lose the benefit of deducting all state and local income tax on their federal returns. For example, some states, such as California and Illinois, have passed bills that allow taxpayers to make charitable contributions to a state fund rather than pay state taxes.

The Internal Revenue Service (IRS) and the Treasury Department advised they are going to clarify the federal tax treatment of payments made by taxpayers to charitable fund set up by state and local governments. A recent IRS Notice states that it and the Treasury Department will propose regulations to address state workaround legislation.

SALT Deduction after the TCJA

The federal Tax Cuts and Jobs Act (TCJA) put a temporary $10,000 cap on the SALT deduction under IRC Sec. 164. Specifically, the cap limits the deduction on individual tax returns for state and local:

  • property taxes; and
  • income taxes and general sales taxes.

For a married taxpayer filing a separate return, the cap is $5,000. The cap applies for tax years that begin in 2018 through 2025.

The TCJA did not limit the deduction for state and local real or personal property taxes incurred in carrying on a trade or business or income-producing activity.

States Respond to SALT Deduction Limit

As noted, some states have passed or enacted statutes that allow taxpayers to make charitable contributions to a state or local government fund in addition to or instead of paying taxes. These government funds would serve "public purposes."

Under the workaround legislation, a charitable contribution would lower the amount a taxpayer's state and local taxes exceed the new $10,000 limit on SALT deductions. In addition, taxpayers who make a contribution could also claim a credit or take a deduction against state tax for the contribution.

Finally, charitable contributions are deductible under federal tax law.

IRS Guidance on Payments Made in Exchange for State and Local Tax Credits

In its Notice, the IRS recognizes that states are passing legislation to "circumvent the new statutory limitation on state and local tax deductions." Proposed regulations will address how contributions to state and local government funds are treated for federal tax purposes when the contribution satisfies state and local taxes. Further, the IRS makes clear that substance-over-form principles will support the federal tax regulatory requirements.

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