The Treasury Department and the IRS intend to propose regulations addressing the federal income tax treatment of certain payments made by taxpayers for which taxpayers receive a credit against their state and local taxes. The IRS does not like the fact that some state legislatures are trying to circumvent the tax deduction restriction.

Section 11042 of “The Tax Cuts and Jobs Act,” Pub. L. No. 115-97, limits an individual’s deduction under § 164 for the aggregate amount of state and local taxes paid during the calendar year to $10,000 ($5,000 in the case of a married individual filing a separate return). Normally those state or local tax payments are fully deductible on an individual’s Schedule A. However, with the new tax law, state and local tax payments in excess of the $10,000 limit are not deductible. This new limitation applies to taxable years beginning after December 31, 2017, and it sunsets January 1, 2026. This may affect many taxpayers who otherwise would have been able to file a Schedule A, Itemized Deductions, and claim greater state/local tax payments as well as other deductible expenses.

In response to this new limitation, some state legislatures are considering or have adopted legislative proposals that would allow taxpayers to make transfers to funds controlled by state or local governments, or other transferees specified by the state, in exchange for credits against the state or local taxes that the taxpayer is required to pay. The aim of these proposals is to allow taxpayers to characterize such transfers as fully deductible charitable contributions for federal income tax purposes, while using the same transfers to satisfy state or local tax liabilities.

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. If taxpayers claim additional state/local tax payments as “charitable contributions,” the IRS may disallow the deduction. This could open an audit.

In an attempt to curtail the legislative activity, the Treasury Department and the IRS intend to propose regulations addressing the federal income tax treatment of transfers to funds controlled by state and local governments (or other state-specified transferees) that the transferor can treat in whole or in part as satisfying state and local tax obligations. The proposed regulations will hopefully make clear that the requirements of the Internal Revenue Code, informed by substance over-form principles, govern the federal income tax treatment of such transfers. The proposed regulations will hopefully assist taxpayers in understanding the relationship between the federal charitable contribution deduction and the new statutory limitation on the deduction for state and local tax payments.

If you have a tax problem, contact McFARLANE LAW – A Tax Law Firm at 480.991.0032.

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