IRS takes aim at California and other states trying to help residents avoid new tax-deduction limit

Reporting from Washington —  The Internal Revenue Service is preparing to block attempts by California and other states to help their residents avoid a new limit on the deductibility of state and local taxes included in the Republican tax overhaul.

The IRS and the Treasury Department said Wednesday they would issue proposed regulations “in the near future” addressing legislation in states that would allow taxpayers to claim a charitable deduction for their state and local tax payments above the $10,000 limit set in last year’s tax law.

“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,” the IRS and Treasury Department said.

California and New York are among the states that have been looking for ways around the limit on state and local tax deductions that Republicans included in the tax cut legislation that took effect Jan. 1.

Many of the states hardest hit by the limit are high-tax ones controlled by Democrats, and leaders there have complained the tax bill targeted the deduction for political reasons.

“The sun came up, so naturally the Trump administration launched yet another attack on California and states that overwhelmingly rejected (President Trump’s) candidacy,” said California state Sen. Kevin de Leon (D-Los Angeles), who is pushing legislation to circumvent the deduction limit.

The state and local tax deduction had been unlimited, and the change will generate billions of dollars a year in additional revenue to the U.S. Treasury to help offset money lost by the bill’s cuts to corporate and individual rates. State workarounds could reduce the amount of money generated by the cap, adding to the already increasing federal budget deficit.

The average state and local deduction taken by the 6.1 million California residents who filed for it in 2015 was $18,438, according to the Tax Policy Center. Only New York and Connecticut had a higher average deduction.

A bill from De León would give residents a dollar-for-dollar charitable tax credit for state income tax payments into a new California Excellence Fund, which would pay for state services.

Taxpayers would be able to deduct the contributions to the fund on their federal returns. There are no limits on charitable deductions.

The state Senate approved the legislation in January. A similar bill is pending in the Assembly and could be voted on in August, according to De Leon’s office.

Last month, state legislatures in New York and New Jersey passed similar legislation. Several other states reportedly are considering the same kind of workaround.

New York Gov. Andrew Cuomo, a Democrat, said his state took action to “ensure New York families weren’t being used as a piggy bank to pay for tax cuts for big corporations.” He vowed to keep fighting what he called “a disastrous tax bill.”

“The IRS should not be used as a political weapon, and I urge this administration to stop its partisan assault on New Yorkers and instead work with us to deliver real, lasting relief for hardworking families,” Cuomo said in a statement.

Jared Walczak, a senior policy analyst at the conservative-leaning Tax Foundation, said the state moves were “legally dubious.”

“Although existing statutes and case law are already clear on this point, formal IRS guidance will help ensure that taxpayers do not face penalties or higher overall tax liability from relying on questionable state guidance,” he said.

Rep. Kevin Brady (R-Texas), who helped draft the Republican tax bill, said state and local officials should focus on reducing their taxes rather than circumventing a law he said has boosted the U.S. economy.

“It’s unfortunate that some politicians are still trying to discredit this new economic momentum in defense of high taxes and stagnant growth,” he said. “I applaud the administration for responding to these gimmicks.”

But seven tax experts released a 44-page paper in January arguing that states would be allowed to turn tax payments into charitable contributions.

The IRS already allows people to claim contributions for payments to more than 100 charitable programs in 33 states. Some of them fund state-supported activities such as public schools and college scholarship programs, said one of those experts, Kirk Stark, a UCLA law professor who has studied the issue.

Stark said Wednesday that it would be difficult for the IRS to draft regulations that allow those programs to continue while invalidating efforts like those of California and New York to use credits for state and local taxes.

Unless the IRS eliminates all such programs, he predicted their new rules “will be subject to rigorous litgation.”

De Leon said he was prepared to go to court if his legislation is enacted and challenged by the IRS. “Try as they might, the IRS doesn’t get to unilaterally rewrite long-standing case law,” he said.

The IRS notice did not specify what the new rules would say about the attempts to turn state and local tax payments into charitable contributions. But a statement by the Treasury and IRS said, “The proposed regulations will make clear that the Internal Revenue Code, not the label used by states, governs the federal income tax treatment” of such payments.

In December, the IRS stepped in after some communities moved to allow residents to prepay 2018 property taxes before the end of last year to possibly avoid the new limit. The IRS said those payments would be deductible only if the taxes for the year in question had already been assessed.

[email protected]

Twitter: @JimPuzzanghera

UPDATES:

2:55 p.m.: This article was updated with comments from California State Sen. Kevin de Leon and UCLA professor Kirk Stark.

12:55 p.m.: This article was updated with comments from New York Gov. Andrew Cuomo and Texas Rep. Kevin Brady, along with additional details.

This article originally was published at 11:10 a.m.