Wednesday, January 10, 2018

A better way to explain the introduction of credits against states' income taxes to serve charitable objectives

There has been a whole lot of talk recently (from me as well as others) concerning how state and local governments should respond to the drastic curtailment of federal income tax deductibility for state and local income and property taxes.

One theme that has emerged is that states can encourage charitable giving by taxpayers, to causes that the states will help fund, in lieu of direct state and local tax deductibility. E.g., taxpayers can give donations to state entities, perhaps serving particular purposes, that are creditable (in whole or large part) against, say, one's state income tax liability.

It occurs to me that proponents of examining this response (including me) have at times not been charitable enough to themselves regarding how this effort should be described.

Suppose a state offers 95% credits against state income tax liability, for contributions to state-run charitable entities that serve broad "silos" that are dedicated to different purposes - healthcare, housing, education, infrastructure, public safety, etc. And suppose the amounts are indeed dedicated, such as via a "trust fund" methodology, to the indicated purposes, although annual spending levels may be constrained to, say, 100% or 105% of the amount the legislature had separately designated for spending in the areas that these silos represent.

As I and others have been discussing, there is a risk of the IRS making "substance over form" challenges to these efforts, under the view that the state-creditable charitable contributions are "really" just re-labeled state and local tax payments.

But consider Point #1: If you build enough economic substance into it, it works. The analogy to economic substance in business deals is important, because there one typically has to have a pretax profit motive and business purpose. Here, we are talking about what people want to do about issues that they care about from a charitable standpoint. So just as in the famous Learned Hand quote about no one having an obligation to pay more federal income tax than is due, here it's okay that one was mindful of the federal income tax benefits of doing it this way, so long as there was indeed charitable purpose and charitable substance to what the taxpayer did. (Meaning here the donor, but he or she will be responding to the institutional setup that the state government has decided to offer.)

Then there is Point #2: There is absolutely no reason to think of this as trying to end-run the limit on state and local tax deductibility. Rather, it is about serving the objectives that were previously served by tax-funded state and local government spending. It's about advancing healthcare, public safety, education, etcetera, via the best mechanisms available, which is partly a function of how Congress has decided to structure federal income tax deductibility.

If (1) Congress decides to continue granting deductions for charitable contributions that advance public goals, but to limit state and local income tax deductions (above the $10K level) that could fund spending advancing the same goals, and (2) states and individuals restructure so that they are now doing things the way that Congress apparently likes, rather than the way that it apparently (at least relatively) dislikes, they aren't avoiding Congressional intent - they are fulfilling it.

To say that one was just looking for end runs would be both inaccurate and unfair to the actual motivations that are at work.  What's really at issue here is the underlying objectives (healthcare, public safety, infrastructure, income support, etcetera). It is not the use of one means versus another as an end in itself. What Congress has addressed is the use of one means versus another, and proponents of restructuring state charitable credits are taking it at its word, and seeking to do what it has encouraged them to do, in the way that it has encouraged them to do it.

Tuesday, January 09, 2018

Restoring state and local tax deductibility through self-help

Eight eminent tax law professors have coauthored an important new SSRN piece entitled "Federal Income Tax Treatment of Charitable Contributions Entitling Donor to a State Tax Credit." It's available here.

Just for the record, as all are good friends and outstanding members of the field, they are: Joe Bankman, David Gamage, Jacob Goldin, Daniel Hemel, Darien Shanske, Kirk Stark, Dennis Ventry, and Manoj Viswanathan.

The piece addresses the issue of what state governments can do to address the repeal of state and local income and property tax deductibility by individuals above the first $10,000. Plus, it addresses whether the federal government should respond, either administratively or legislatively, to such state government responses.

In particular, the question presented is whether states can tax-effectively rely on charitable contribution credits against state tax liability, and thereby permit their own taxpayers who take advantage to claim federal charitable deductions.

To illustrate the basic idea, suppose I would pay New York State (and New York City) $100,000 of income taxes if I did nothing differently in the future than I have in the past. But now suppose that I can reduce my New York State and City income tax liability, dollar-for-dollar, by making charitable contributions to designated state and local government entities. E.g., I give $90,000 in such contributions, and thereby reduce my remaining liability to $10,000 that falls within the deduction limit.

For this to offer maximum benefit, the income taxes would need to be provide 100% credits against such liability for particular donations. There are already some such provisions in existing state and local income tax law, however, as the article documents in its appendix. And these have generally been held, by case law and/or administrative rulings (with and without express precedential effect), to work for federal income tax purposes. That is, one gets the full charitable deductions contribution for the amount one paid that was 100% creditable against state and/or local income tax liability.

There are two main legal obstacles to success of this gambit under federal income tax law.* The first is allowance of the full federal charitable deduction despite any issue regarding the state tax law benefit that one garnered by reason of making the charitable contribution. By analogy, suppose I gave $100 to NPR and got a bookbag that is worth $20. Then my federal charitable deduction would be limited to $80, i.e., to the gift minus the offsetting benefit. So legal question #1 in the above scenario is whether my federal charitable deduction would be offset by the value of the state income tax saving.

The second main federal legal obstacle to success is substance over form doctrine. Am I actually, in substance as this question is analyzed for federal income tax purposes, making a charitable contribution, rather than simply relabeling my state income tax liability?

The first main point that the article makes is that current legal authority, both from cases and IRS administrative pronouncements, strongly supports what it calls the "Full Deduction Rule."  This rule holds that "the amount of the donor's charitable contribution is not reduced by the value of state tax benefits." In short, legal obstacle #1 as described above should not prevent the relabeling from working.  As a matter of formal legal analysis, the main point here is that the state and local income tax liability doesn't actually exist until one fully applies the pertinent law. So the fact that the income tax liability never arose, due to the credit, means that there was no legally cognizable benefit. Again, the article shows that this line of reasoning has repeatedly been upheld.

The second main point that the article makes is that there are good policy rationales in favor of continuing to allow the Full Deduction Rule to apply. E.g., does one draw the line at 100% credits? Should charitable deductions generally be reduced for the value of state and local charitable deductions? Must taxpayers always compute alternative state liabilities with and without the credits? Etc.  Plus, the article argues that the Full Deduction Rule serves important federalism values and is consistent with decades of federal tax policymaking. Hence, "Congress should tread carefully if it seeks to alter the Full Deduction Rule by statute."

I find these arguments convincing. But there is still the issue, not addressed by the article as it would require a much longer and largely distinct analysis, of the circumstances in which 100% (or lesser) credits against state and local income tax liability, for charitable contributions to particular state entities, would have economic substance.

Here is a preliminary thought of mine regarding one way of establishing the requisite economic substance. Key word here is preliminary: A lot of people need to weigh in on this, regarding both federal income tax law and state and local government practicalities.

Suppose a state government offers large buckets to which one can charitably designate one's charitable contributions that generate a 100% credit against the tax liability. E.g., Medicaid and Public Health; Schools; Infrastructure, etc. Suppose there were 4 or 5 buckets and that one could get a 100% credit for up to X% of one's state income tax liability by making such designated contributions, but that no more than Y% could go to any one bucket.

The state government would still determine overall annual spending in each category, which wouldn't be directly affected by taxpayers' charitable contribution designations. (NOTE - these contributions probably should be required to be paid separately and prior to the state tax itself - not by designation on the state income tax return.)

So where's the economic substance? Point #1, I get to decide where "my" dollars, as opposed to someone else's, go. Many people actually care about this, as a matter of subjective psychological fact.

But what if the designations to a given category exceed what the state wants to spend on that category? Simple. The state designates those extra $$ as notionally in a "trust fund" that it currently pledges WILL be spent on that budgetary purpose in the future. Consider the analogy to the Social Security Trust Fund. My FICA payroll taxes ostensibly "will" be spent at some point on paying Social Security benefits. Now, budget aficionados may think this doesn't really mean much. But actual voters and taxpayers, and perhaps even the U.S. Congress, actually do think it matters. So who are we to second-guess them? (Especially as they may be correct in the sense of the Trust Fund's affecting likely future political outcomes.)

Hence we get Point #2 for economic substance. My, say, Medicaid-designated contributions WILL, the state now pledges, be spent on Medicaid or other public health either this year in the future. A trust fund pre-commits them to be spent in this way. Sure, the state could change the law next year and take back the promise without recourse on the donor's part. But, just as in the case of the Social Security Trust Fund, the donor gets the benefit of the political force, if any, that the designation might have in the future. Plus, the state legislators are getting what they might deem valuable information about taxpayer sentiment.

Do others agree with the economic substance analysis that I offer here? Are there other features that they'd deem important? Can states make this workable for themselves and their taxpayers, without undue inconvenience on either side? I am hoping that others will address these issues as well.
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* Extra challenges may arise making this practically workable in the case of (a) local as well as state income tax liability, and (b) property taxes that often are paid to a smallish local government unit.