As the details of the Tax Cuts and Jobs Act were being worked out, one provision attracted a great deal of attention: state and local tax caps (SALT caps). Ultimately, deductions for state and local sales, income, and property taxes typically deducted on a Schedule A remain in place but are limited.
Under the new law, the amount that you may claim on Schedule A for all state and local sales, income, and property taxes together may not exceed $10,000 ($5,000 for married taxpayers filing separately). This cap is concerning for taxpayers in high-property-tax states like California and Texas, as well as those in high-income-tax states like New York and New Jersey.
Following the new law, states scrambled to come up with novel ways to re-characterize tax payments to keep taxpayers happy (and clearly, inside their geographic borders). Some states have proposed variations on state and local charitable funds or trusts which would accept payments from taxpayers in satisfaction of state and local tax liabilities. The idea, of course, is that those payments would then be re-characterized as fully deductible charitable contributions for federal income tax purposes.
Pretty brilliant, right? Not so fast.
The Internal Revenue Service (IRS) has released Notice 2018-54 (downloads as a PDF), advising that it intends 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.” While the IRS hasn’t indicated what exactly those regulations would entail, the agency did offer some insight, noting:
The proposed regulations will 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 substance-over-form principle can be boiled down to the adage, “If it looks like a duck, swims like a duck, and quacks like a duck, then it probably is a duck.” In other words, you typically can’t repackage one thing (like a deduction for state and local taxes) as another thing (like a charitable deduction) and pretend it’s not the first thing. Or put another way, intent matters: Your tax return and financial records should reflect the economic reality of a transaction and not be an attempt to hide the real intent.
The notice continues, “The proposed regulations will 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.”
The notice does not indicate when the proposed regulations will be released. So what should you do in the meantime? The IRS suggests that you “be mindful that federal law controls the proper characterization of payments for federal income tax purposes.” While it’s tempting to throw your dollars at new schemes, even well-intentioned ones blessed by your state legislature, this is new ground. Proceed with caution.