IRS targeting tax law workarounds in states like New York

Jun 1, 2018

The nation's new tax law places a cap on the amount of state and local taxes that someone can deduct from their taxable federal income. That caused panic in high-tax states like New York. So the state's lawmakers amended their tax system to mitigate the increased costs for New Yorkers - changes the federal government may soon attempt to nullify.

In its budget, the New York State Legislature enacted two so-called workarounds to the new $10,000 cap on state and local tax deductions. One would allow businesses to opt into a payroll tax system where the employer would pay the employee's equivalent of income taxes and lower their salary by the same amount. Payroll taxes would be deductible against your federal income taxes.

The second workaround is the establishment of new charitable funds to pay for public services like healthcare and education. New Yorkers could "donate" their state income taxes above $10,000 into these funds and use the unlimited charitable contribution deduction to lower their taxable federal income.

"So on balance you’re better off, but there’s a lot of uncertainty about this," said Leonard Burman, co-founder of the Tax Policy Center and a professor at Syracuse University's Maxwell School of Citizenship and Public Affairs.

Burman says there are potential legal issues with characterizing taxes one owes to the state as a gift to charity. And to that effect, the IRS has recently released a memo announcing its intention to propose regulations on what counts as charitable contributions. "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 memo said. 

"They’re skeptical of these schemes and if they decide this isn’t really charity, then basically these things don’t work," Burman said.

But Kirk Stark, a tax law and policy professor at UCLA, says it may not be so easy for the federal government to quash New York's workaround. New IRS regulations would need to go through a public review and comment period, allowing New York leaders a chance to craft any changes. Many other states would likely participate in that review, Stark says, because the current chartiable contribution system is used by many states to support programs that may also not count as charity, like charter schools.

"I'm sure that all of these private school voucher programs and advocates for those programs will be urging the IRS to preserve rule that has been in place for over 100 years now that we have never required any donor to any charitable entity to reduce the amount of their charitable contribution deduction by the value of the tax benefits arising from having made that gift," Stark said.

Any new restrictive regulations from the IRS will also likely be challenged in court.

Stark says the best way to resolve the matter is for Congress to pass new legislation.