The tax reform package that passed through Congress and the White House late last year was contentious, with most of the discussion of the measures dividing neatly along party lines. One of the most controversial portions of tax reform was its limitation of itemized deductions on state and local taxes to $10,000, a move that many high-tax states took as being politically motivated. In response, some of those states have looked at a number of possible responses to preserve deductions, arguably in an attempt to circumvent the intent of federal law.

Last week, though, the Internal Revenue Service struck back against states looking for ways to work around the new provisions. A notice from the IRS warned that coming regulations from the Treasury Department will clarify deductibility of state and local taxes for federal purposes, and that they might not match up with what rebellious states have in mind.

Brick wall with Internal Revenue Service nameplate on it.

Image source: Getty Images.

What tax reform did to the state and local tax deduction

Under old law, taxes paid to state and local government entities were generally eligible for an unlimited deduction for those who itemize rather than taking the standard deduction. Specifically, there was no limit on the amount of property taxes one could claim as a deduction, and taxpayers could choose either to take the amounts they paid for state and local income taxes or the amount they paid in sales taxes as an additional deduction.

Tax reform efforts had initially sought to eliminate the deduction entirely. In a compromise, a provision limiting the total deduction to $10,000 appeased taxpayers in many states with more moderate tax burdens. However, tax rates were still high enough in areas like New York, New Jersey, and California to make the $10,000 limit have a dramatic impact on federal tax burdens for their residents, and state legislators there looked at measures that could potentially come up with alternative rationales to justify federal deductibility.

How states responded

Specifically, states looked for ways to recharacterize state tax payments that were subject to the limits as unlimited charitable contributions. New York has established a state-run charitable fund that would accept donations, offering a tax credit against their state tax bills. For every $100 taxpayers give, they'd get an $85 tax credit against New York state taxes. A similar proposal in California would give residents a 100% dollar-for-dollar state tax credit for donations to what's called the California Excellence Fund to help pay for government services.

New Jersey authorized a broader law that would allow counties, towns, and school districts to come up with their own charitable funds. Under the provision, local government entities could offer tax credits of up to 90% for donations to the funds.

The IRS prepares for battle

Yet federal authorities aren't happy with the state moves. In a notice [opens PDF] on May 23, the IRS warned that "despite these state efforts to circumvent the new statutory limitation on state and local tax deductions, taxpayers should be mindful that federal law controls the proper characterization of payments for federal income tax purposes.

The interesting question is whether future Treasury Department regulations will try to single out these latest moves while letting states that have had similar frameworks continue to use them. In a review of a Missouri law that allowed a 25% state tax credit for donations to shelters for domestic violence victims, the IRS said that the state tax benefit from the donation didn't negate the charitable intent of the gift. Federal officials will be able to argue that there's a big difference in charitable intent in a gift made in exchange for a 25% state tax credit than for a gift with an 85%, 90%, or 100% tax offset, but some tax policymakers aren't as convinced that the distinction is legally valid.

Keep your eyes open

With some of these charitable options already available, it's important for taxpayers to watch closely how Washington reacts. If you give $100 hoping to get an $85 state tax credit plus a federal deduction worth as much as $37 more, you could end up $15 worse off if the IRS denies the deduction on the federal return. For some, though, the risk will be worth it, given the potential rewards if they win.

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