States Sue to Invalidate IRS Regulations on Charitable Contribution “Workarounds” of $10,000 State/Local Tax Deduction Limit

As reported by Worldwide ERC® in June, the Internal Revenue Service finalized regulations denying charitable contribution deductions for most contributions to state and local sponsored charities for which the individual donor receives a tax credit. (See IRS Issues Final Regulations on State and Local Tax “Workarounds.”) Since that time there have been additional developments, including a lawsuit to overturn the regulations, as well as efforts to do so in Congress. And questions have begun to be raised about other “workarounds” enacted by some states.

On July 17, 2019, the states of New Jersey, New York and Connecticut sued the federal government, arguing that the new regulations violate the Administrative Procedure Act and Regulatory Flexibility Act and are thus invalid. These are the same states that have been pursuing a lawsuit arguing that the law itself is invalid. A similar suit was filed on the same date by the Village of Scarsdale in New York, on behalf of the Coalition for the Charitable Contribution Deduction, which includes a number of New York counties, municipalities, school districts, and advocacy organizations, and is principally concerned with the impact of the new regulations on charitable contribution programs for schools that reward contributors with a tax credit. Both lawsuits will proceed through the court system but are unlikely to be resolved rapidly.

Elsewhere, on July 16, 2019, a group of Democratic Senators from the states most affected, led by Senator Schumer of New York, filed a “Resolution of Disapproval” of the regulation under the Congressional Review Act. A similar bipartisan resolution was introduced in the House by 48 lawmakers. The resolution would give Congress the ability to review and disapprove any federal regulation so long as Congress acts within 60 legislative days of the publication of the final regulation. Such disapproval would only need a majority of the Senate. However, most observers believe it is unlikely to pass.

In the meantime, the IRS reportedly continues to work on additional regulations addressing other types of state workarounds, with a goal to issue proposed regulations this summer. Among the issues reportedly to be addressed is the treatment of new state laws that impose either a mandatory or elective tax at the organization level for pass-through businesses such as S-Corporations and partnerships, coupled with a corresponding tax credit at the individual owner level. The Tax Cuts and Jobs Act provision limiting state and local tax deductions to $10,000 applies only to individuals. The effect of the pass-through strategy is to impose tax at the business level, at which it is argued that it is fully deductible, with a corresponding credit to relieve the individual owners of the burden of the tax.

Connecticut was the first state to enact such a law, and the only one in which the new entity level tax is mandatory. According to the state’s Revenue Commissioner, about 110,000 pass-through entities are participating in the program. Four other states (Wisconsin, Louisiana, Oklahoma, and Rhode Island) have enacted similar legislation, but under which the entity level tax is optional.

According to some reports, IRS is considering disallowing such programs on the basis that the entity taxes are not stand-alone business taxes but are instead simply a substitute for the state’s personal income tax. Tax professionals differ on whether such an approach would have validity, but it seems likely that uncertainty will continue for some time

How This Impacts Mobility

Because these issues affect the tax liability of employees in high-tax states, and the tax liability of highly compensated employees, they will also continue to affect gross-up calculations for Worldwide ERC® members.

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