On Dec. 22, 2017, the Tax Cuts and Jobs Act was signed into law and fundamentally reformed the federal tax system in the United States. Among the many changes, tax reform modified a long-standing federal deduction for state and local taxes.

The SALT deduction, as it's often called, previously allowed taxpayers to deduct the full amount of their state and local taxes from federal taxable income. Now, taxpayers are limited to deducting just $10,000 total, including property and income taxes.

Capping the SALT deduction was a change New York Governor Andrew Cuomo said would "destroy" New York. With Cuomo so concerned about the impact, it came as no surprise when New York became the first state to try circumventing  new federal rules to protect SALT deductions for residents.

Other states have since followed suit, but the legality of their efforts is questionable.

Here's what New York is trying to do to avoid caps on SALT deductions

A recent agreement among state lawmakers on the New York state budget included two different approaches to avoiding federal limits on SALT deductions.

The first involves creating a charitable contribution fund, which is a state-operated charity. The idea is for taxpayers to make these donations in lieu of paying state income tax. Taxpayers who donate to this fund are, theoretically, eligible to deduct the full amount of their donations from their federal taxes since donations for charitable giving aren't subject to the same limits as SALT deductions.

Local government bodies were also authorized to create charitable organizations taxpayers will be permitted to donate to in exchange for property tax credits. This would make local taxes, including real estate or property taxes, fully deductible.

The second workaround would allow employers to opt into an Employer Compensation Expense Program to voluntarily pay a new payroll tax of 5% on employee compensation exceeding $40,000. Employers would bear the burden of paying employees' state taxes and deduct the cost. Because employees would see lower gross pay, there are provisions in the law to try to keep their net pay the same as before tax reform.

Will these proposed changes help shield New York residents from SALT limitations?

New Jersey and Connecticut have followed New York's lead in creating new programs allowing taxpayers to forego state tax payments and instead make charitable contributions to special state-created charitable funds.

Connecticut also proposed a new income tax on most pass-through businesses while creating new tax credits at the individual or corporate level to offset this tax increase.

However, the IRS has taken notice and the Treasury is currently at work on regulations to curtail state efforts to shield residents from the impact of tax reform. 

The IRS is likely to render the charitable giving workaround impossible, as it released a statement addressing federal tax treatment of funds transferred to charitable organizations controlled by state and local governments. The IRS will consider the substance of these transfers, rather than just the form. Charitable donations are typically deductible only if there's a charitable intent and the donator doesn't receive a substantial benefit. Avoiding state taxes would be a substantial benefit, so the charitable donation deduction would be disallowed.

It's not yet clear if the IRS will address other proposals, such as New York's attempt to create a new payroll tax or Connecticut's new proposed tax on pass-through entities. However, these programs are a lot more complicated and may be met with resistance by workers who will see their gross salary decline and businesses disinterested in incurring new tax obligations.

What happens next?

New York, New Jersey, Connecticut, and other states hit hard by capped SALT deductions are unlikely to abandon efforts to shield residents from a big federal tax increase. Many states whose residents are likely to see the biggest tax increases are blue states whose residents reward politicians for defying the Trump administration.

However, the IRS has a lot of power to interpret tax laws and issue new regulations, and taxpayers may not want to take the risk of being audited -- and potentially owing back taxes and penalties -- if the IRS doesn't believe state schemes to preserve SALT deductions pass muster.

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