States Poised to March Through Tax Loophole

 Tax loopholes are normally associated with corporations and wealthy individuals, but top officials in New York and California have announced plans to march through a loophole that would allow their taxpayers to bypass a new federal limit on the deductibility of state and local taxes.

Tax loopholes are normally associated with corporations and wealthy individuals, but top officials in New York and California have announced plans to march through a loophole that would allow their taxpayers to bypass a new federal limit on the deductibility of state and local taxes.

High-tax blue states such as New York and California may join the parade of tax avoidance planners looking for loopholes to march through in the GOP-backed federal tax overhaul to contravene the $10,000 deductibility limitation on state and local taxes.

With the ink hardly dry on new federal tax legislation, New York Governor Andrew Cuomo and California state Senator Kevin de Leon are proposing schemes that would effectively convert state income tax payments into charitable contributions, thus making them eligible as deductions on federal income tax returns.

These aren’t clandestine tax maneuvers. Cuomo announced his intention in his State of the State Address and de Leon spelled out his plan in an interview with NPR’s Robert Siegel. Other states with legislative sessions this year may follow suit.

According to de Leon, “We have no other choice but to move forward with this type of policy because, in the end, the tax policy that was just passed in Washington will disproportionately hurt a state like California. And when you hurt a state like California, you're hurting the rest of the country, because we are the economic engine for the nation.”

One estimate indicates the limitation on state and local taxes (known as SALT) could save the federal government as much as $100 billion per year based on 2017 numbers. Democrats – and Republicans – from states with high income and property taxes claim their constituents would pay a disproportionate share of that $100 billion.

Like most tax issues, there is a lot of room to argue.

Supporters of the $10,000 SALT deduction cap contend that will cover most middle-income taxpayers who itemize expenses on their federal tax returns. Republicans say many more taxpayers will skip itemization and opt to claim the substantially higher standard deduction in the tax bill, arguably simplifying their tax returns.

Critics of the SALT limitation say it will subject middle- and upper-income taxpayers in high-tax states, including Oregon, to double taxation. Data shows 50 percent of the federal deduction for local property taxes comes from just six states – California, New York, New Jersey, Illinois, Texas and Pennsylvania.

The Cuomo-de Leon strategy seeks to exploit a 2011 IRS ruling that treats a donation to a state’s General Fund as a charitable contribution and therefore a deductible expense. De Leon contemplates a California tax scheme where every $1 in “contributed” taxes qualifies a taxpayer for a $1 tax credit.

“That is the law,” de Leon says. “That is permissible. So what we're doing is en masse taking advantage of this opportunity to do a roundabout, if you will, against policies from Washington that are very hurtful towards a state like California.”

Asked by Siegel if his scheme passes the “smell test,” de Leon said, “It does pass the smell test because we're already doing it here in California. I authored a measure back in 2014 that allows for charitable donations to state college affordability grants.” He add that other states, including red states such as Florida and Arizona, had enacted similar tax provisions.

Cuomo called the SALT deduction limit “economic civil war” as he called for “dramatic action to save ourselves and preserve our state's economy.” In addition to pursuing the tax-payment-as-contribution loophole, Cuomo said New York would pursue legal action to challenge the constitutionality of the limitation, though legal observers questioned whether legal action will succeed.

Of course, a simpler approach would be for Congress to modify the federal tax legislation to eliminate or raise the state and local tax limitation. After the dust settles and IRS rules emerge implementing provisions in the tax bill, there may be a need for what lawmakers call a technical correction bill to clean up, clarify or cashier hazy, hasty or poorly thought-through provisions.

Despite Democratic opposition to the tax-cut legislation itself, a fix that includes a modification of the SALT limitation could attract bipartisan support and easily pass.