Connecticut’s attempt to safeguard federal deductions may draw IRS heat

Washington – Fairfield First Selectman Mike Tetreau hopes to take advantage of a new state law aimed at blunting the impact on his town’s residents of a new cap on certain federal tax deductions.

“We’re going to do everything we can to see if we can help,” Tetreau said.

The Democratic first selectman thinks it’s “galling” that the new GOP tax overhaul, called the Tax Cuts and Jobs Act, put in place a $10,000 cap on the amount of state and local taxes (SALT) that filers can claim as deductions on their federal taxes.

Tetreau, like many other first selectmen and mayors in the state, wants to allow  constituents to avoid the new caps. But they are sailing into uncharted waters of the federal tax code and the Internal Revenue Service may scuttle their efforts.

Fairfield First Selectman Mike Tetreau.

The cap on SALT deductions, which takes effect in the 2018 tax year, will have greater impact in high-cost states like Connecticut whose residents are — on the average — wealthier than those of other states and pay higher income and property taxes.

“There’s no question that the Trump tax law penalizes Connecticut more than most of the rest of the country,” Tetreau said.

The Tax Policy Center agrees. It says the average New Yorker’s SALT deduction was $22,169. In New Jersey and Connecticut, those amounts were $17,850 and $19,665, respectively.

That has prompted Connecticut, New York and New Jersey to enact new state laws that allow municipalities to create “community supporting organizations” classified as charitable organizations. Taxpayers would make “contributions” to these organizations that are credited toward their tax liability.

Since there is no cap on charitable donations in the new tax law, this would allow Connecticut taxpayers to avoid the cap on SALT tax deductibility.

The IRS has not made a ruling on these new tax laws. But proponents of the Tax Cuts and Jobs Plan warn the use of charitable contributions to pay state and property tax liabilities could be determined to violate the federal tax code.

“We have states turning a charitable contribution into a tax payment, the IRS will see right through that,” predicts Jared Walczak, a senior policy analyst at the Tax Foundation.

Earlier this month, the Connecticut general assembly passed SB 11, legislation proposed by Gov. Dannel Malloy called “An Act Concerning Connecticut’s Response to Federal Tax Reform.”

Once enacted, the bill would impose a new 6.99 percent income tax on most pass-through entities and provide a credit to offset the tax at the personal or corporate income tax level.

That new Connecticut law is aimed at helping a sole proprietor of a business, a person in partnership or owner of a limited liability corporation increase their federal deductibility of the state income taxes they pay. While the new federal law limits the amount of state income tax that is deductible, business taxes continue to be fully deductible.

The law also allows municipalities to provide a property tax credit to eligible taxpayers who make voluntary payments to municipally-approved “community supporting organizations.”

Tetreau said he has tasked his city’s tax lawyer to determine how that system would work, especially since the full donation cannot be taken as a credit toward a property tax bill.

The new state law limits the credit to 85 percent of the donation or the tax due, whichever is the lesser amount.

Under the new state law, Connecticut’s towns have the option of adopting the workaround of cap on SALT deductions or declining to participate.

Rebellion may grow

Before the new federal tax plan was signed into law, there were at least 18 states that turned charitable contributions into tax credits, not to increase federal deductions but to steer funds to key programs.

Arizona, South Carolina, Alabama and Georgia, for instance, are among the states that allow tax credits for donations to school voucher programs.

Missouri gives tax credits for donations to local food pantries and shelters for victims of domestic violence, and many states give credits for land donated for conservation easements.

The steps Connecticut, New York and New Jersey have taken are based in part on a study by eight law professors who specialize in taxes. The study cites efforts in red states to give tax credits for donations to charitable organizations and discusses a  2011 Internal Revenue Service memo that said state and local governments may turn charitable donations into tax credits under certain conditions.

Walczak said that IRS document was just a memo, not a ruling, and it related to specific state and local government attempts to encourage donations to a certain program or cause.

“The programs that were cited were small and have a genuine charitable component and are not intended to recharacterize income to obtain a tax advantage,” he said. “Hopefully… the IRS will provide guidance to the states that the charitable contributions will not work.”

Kirk Stark, a professor at the UCLA School of Law and an author of the study that helped spark the tax rebellion, said there’s no difference between what Connecticut has done and what a number of other states have done to fund school vouchers and promote other programs.

“All the programs in Connecticut, New York and New Jersey are structured on the same legal principles that underlie those programs,” Stark said.

As far as the possibility an IRS determination that a state or town can’t be considered a charity, Stark said Congress has determined that states and political subdivisions are  charitable entities.

“Our democracy has decided that states can receive charitable contributions,” he said. “You can’t have two separate rules. And what do governments do? They fund charities like  education, health care… they are doing the exact same thing as other charities.”

In January, Treasury Secretary Steven Mnuchin slammed states that said they would circumvent the new tax law’s limit on state and local tax deductions.

“It’s one of the more ridiculous comments to think that you can take a real estate tax that you’re required to make and dress that up as a charitable contribution,” he said.

But he declined to say what response the Treasury or IRS might have to those attempts to shield taxpayers from tax hikes.

The rebellion against the capped SALT deductions may grow. California, Washington D.C., Nebraska, Illinois and other states may follow in passing state laws that provide a workaround.

 

 

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