New York and three other Democratic-led states are asking the Internal Revenue Service to withdraw its recent regulation limiting high-tax states’ workarounds to the new $10,000 federal limit on state and local tax deductions.
Tax attorneys expect the request to fall on deaf ears.
New York, Connecticut, New Jersey, and California, in comments submitted to the IRS Oct. 11, said the proposed regulations, which severely limit the amount of state charitable contributions that can be deducted for federal income tax purposes, would upend years of precedent without any authority from Congress and would arbitrarily and capriciously favor some charitable contributions over others.
At issue for New York and other states are newly created charitable deductions that are designed to get around the 2017 federal tax law’s (Pub. L. No. 115-97) $10,000 limit on state and local tax deductions. New York, for example, allows taxpayers to get a tax credit for contributions made to charitable funds designed to support education and health care programs.
In May, the IRS announced that it would address state attempts to use charitable contributions to sidestep the cap. The IRS aimed proposed regulations at workaround programs in high-tax states like New York, New Jersey, California, and Connecticut in an attempt to prevent residents from avoiding the new cap. Under these proposed regulations, donors who receive a state or local tax credit would have to reduce any federal deduction for that contribution by the amount of the state tax credit.
“The odds of the IRS altering these regulations are at best remote, more likely, nonexistent,” Edward A. Zelinsky, the Annie and Morris Trachman Professor of Law at Yeshiva University’s Benjamin N. Cardozo School of Law, told Bloomberg Tax in an email.
The comment letter, along with a letter from the New York state tax commissioner, repeats many of the arguments that Gov. Andrew M. Cuomo (D) and other Democratic governors have been making against the tax law and the regulations. Still, the letter makes its arguments in great detail, indicating the legal arguments the states will likely make if they challenge the regulations in court.
New York and three other northeastern states are already challenging the law in federal court.
Richard D. Pomp, the Alva P. Loiselle Professor of Law at the University of Connecticut School of Law, described the letter as “more grandstanding, just like the case the four states have brought against the federal government.”
Peter L. Faber, a partner at McDermott Will & Emery, said there is sufficient legal basis for the regulations.
Faber said the states would be creating “a wonderful tax shelter” if their view prevailed.
“I could make a gift to one of these New York government agencies and get a credit of almost all of the gift, so it would cost me virtually nothing,” he told Bloomberg Tax in an email. “If, in addition, I get a federal income tax deduction, I have actually made money by making a gift.”
“Their basis is the time-honored principle that the substance of an arrangement prevails over its form in applying the tax laws,” Faber said. “If I make a ‘gift’ to a New York-sponsored entity and get a full credit against my New York State personal income tax, how can that be described as anything other than a payment of my tax? It has exactly the same economic effect.”
One of the state’s key arguments against the regulation is based on a Sept. 5 clarification in which the IRS said that businesses could still deduct business-related contributions to charities in return for state and local tax credits. The states argue that this arbitrarily and capriciously favors businesses over individual taxpayers.
The states also argue that applying the so-called quid pro quo doctrine—in which the value of goods and services must be subtracted from the amount of a deduction—is contrary to longstanding tax principles.
“Case law and the IRS’s own administrative guidance have uniformly held that the expectation of a tax benefit does not give rise to a quid pro quo that would negate charitable intent or reduce the amount of a charitable deduction,” the states said in their comments.
“Despite a huge number of federal tax overhauls, and the sometimes enormous tax benefits received, federal tax law has never considered tax benefits received as a consequence of a charitable gift to be a quid pro quo,” the states said.