N.Y. Gov. Andrew Cuomo (left).
Photo by Cpt Mark Getman, New York Guard State Defense Force, courtesy the New York National Guard.
When are state income taxes not taxes at all? When they’re gifts – at least in New York.
New York’s recent budget included new rules to try to work around the $10,000 limit on deducting state and local taxes on a taxpayer’s federal return imposed by the 2017 Tax Cuts and Jobs Act. New York Gov. Andrew Cuomo’s office estimates that this new limit will cost 1.7 million of the state’s taxpayers, primarily in New York City and its surrounding suburbs, an estimated $14.3 billion. The new workaround comes in two parts: an optional payroll tax and state charitable contribution funds.
The payroll tax is fairly straightforward, and most tax experts agree it will hold up to legal scrutiny. New York employers can opt in to the voluntary system called the Employer Compensation Expense Program, or ECEP. The 5 percent payroll tax will be fully deductible for employers, and employees subject to the ECEP would receive a credit to ensure they experience no net decline in take-home pay. While this system is probably legal, it is not clear how many employers will participate, especially since it will require they either reduce salaries or accept increased employment costs.
The more legally sticky half is New York’s two proposed charitable contribution funds. Cuomo’s plan calls for one fund that will support education and another that will support health care. Taxpayers could “donate” to these funds and receive a partial tax credit against their state and local taxes – 85 percent for the former and 95 percent for the latter, if school systems and municipalities act on Cuomo’s suggestion that they set up charitable funds of their own. The idea is that charitable contributions remain deductible for federal tax purposes, unlike state and local taxes in excess of the $10,000 limit, so donating to these funds would allow taxpayers to circumvent the new cap. While not everyone with taxes above the threshold would necessarily benefit – they would also need total itemized deductions in excess of the new increased standard deduction – many New Yorkers will be very motivated to donate to these funds.
It is all but certain that the Internal Revenue Service will challenge the charitable contribution fund method. While New York is the first state to specifically institute workarounds for the state and local tax deduction limit, similar solutions are pending in states like California and New Jersey.
Those who support New York’s strategy on grounds other than wishful thinking have pointed out that other states already offer charitable funds that work in similar ways, unconnected to the recently passed tax reform. For instance, in my home state of Georgia, taxpayers can donate to designated student scholarship organizations, which provide scholarships to students who wish to attend private schools, or to rural hospital organizations and receive a full or partial tax credit. I have taken advantage of the scholarship organization credit for many years, largely because I believe in the specific organization I support. Previously, this had no particular advantages where federal taxes were concerned. But now Georgians who will run into the $10,000 deduction threshold for state taxes will have a serious incentive to consider effectively turning state tax dollars into deductible charitable contribution dollars.
This type of program isn’t limited to Georgia. More than a dozen other states offer similar tax credit programs for scholarship funds, for example. And a variety of states offer tax credits for other sorts of charitable donations, including those to hunger relief organizations (Colorado), eligible community foundations (Maryland) and various local nonprofit organizations (Missouri). Many states use tax credits to encourage their residents to support a variety of causes.
So if these established programs are fine with the IRS, why do some tax experts say New York’s plan won’t hold up under scrutiny? It is largely because deducting charitable contributions is only permitted if you do not get a personal benefit. If you pay $500 to attend a charity gala and receive a dinner valued at $100, you can only deduct $400, rather than the full gift.
Legal precedent and IRS rulings have established that the taxpayer does not necessarily need to reduce the charitable contribution by the amount of the state tax benefits received. With programs like Georgia’s, you are donating to organizations approved by the state, with specific and limited aims. In other words, it is not unreasonable to argue that individual donors are giving altruistically, even if they receive a state tax credit for their trouble.
Arguing the same for New York’s charitable funds would be much harder. Taxpayers are not only benefiting from government services, but also benefiting from a reduction in tax liability, without which they almost certainly would not be interested in making such a “gift.” Jared Walczak, an analyst for the nonpartisan think tank the Tax Foundation, represented many critics’ misgivings when he said bluntly: “The IRS is highly unlikely to go along with this charade, as these so-called contributions bear none of the hallmarks of genuine charity.”
It would not surprise me if New York’s plan ended up in court. In the fairly likely instance that the state loses such a case, what will become of tax credits like the one I’ve used in Georgia? It is possible that they are different enough that a legal challenge to New York could leave them unscathed, but it is also possible that they will get swept away in the aftermath. As for New York taxpayers who take advantage of the state’s charitable contribution funds, taking the state at its word could, at a minimum, leave them open to a greater risk of an audit by the IRS.
Congress would do better to close this loophole with legislation, and save everyone the time and expense involved in dragging the New York system and other similar schemes through the courts. Even if it shuts out programs like Georgia’s, it will be one less opportunity for taxpayer aggravation as we adjust to the effects of tax reform.