Recharacterizing State Tax Payments as Charitable Contributions

The recently-passed Tax Cut and Jobs Act of 2017 has produced a wide array of new rules governing federal income taxation.  Perhaps one of the more controversial aspects of the new tax law (at least in states where taxpayers pay disproportionately high state and property taxes) is the cap on deductions for state, local, and property taxes – the “SALT” tax deduction.

Under the former tax law, a taxpayer itemizing her deductions could deduct 100% of all state income tax, local tax, and state and county property tax payments from her federal income.  Last year, more than five million California residents took advantage of these rules by deducting more than $80 billion in state and local taxes from their federal income tax returns.

The new law caps the total deduction for these payments at $10,000 per year.  Thus, a California taxpayer paying $10,000 a year in state tax, and $5,000 per year in property tax will see his or her SALT deduction reduced from $15,000 to $10,000.  The politics behind the decision to cap the SALT deduction is best left for a different article (and author), but the upshot for many California residents that itemize their deductions is likely a higher federal income tax bill.

On January 3, 2018 the California legislature introduced Senate Bill 227 in an effort to ameliorate the potentially harmful financial effect of the reduced SALT deduction on California taxpayers.  If passed, SB 227 would allow Californians to contribute money to a newly-created “California Excellence Fund”.  The Fund will use all monies contributed towards public purposes (indeed, the same public purposes that California state taxes go towards) and the taxpayer contributing to the fund will receive a dollar-for-dollar tax credit for monies contributed to the Fund.  In short, if your state income tax bill is $10,000, rather than pay the tax bill you can elect to contribute that $10,000 to the Fund and receive a California tax credit of $10,000.  From a state tax perspective, the Fund is thus neutral to the taxpayer.

However, according to its authors, the real benefit of SB 227 is that any monies contributed to the Fund would technically qualify as a contribution to a public agency, which the IRS recognizes as a type of charitable contribution.  And since the new tax law does not limit deductions for charitable contributions, SB 227 would allow California taxpayers to do an end-run around the SALT deduction cap, and deduct the full amount of their state income taxes (or at least that portion paid into the Fund rather than directly to the Franchise Tax Board).  This seems too … easy.  And with tax law nothing ever is.

Fundamentally, in order for a charitable contribution to qualify for a federal income tax deduction the contribution must actually be charitable; the taxpayer receiving some benefit or quid pro quo in exchange for the contribution cannot take the deduction up to the value of the benefit received in return.  By way of example, if you donate $100 to a charitable organization but receive a $20 gift card in exchange, the charitable aspect of your donation is $80 and that is the amount you can deduct for tax purposes.

In order for a donation to a public entity to qualify as a charitable contribution, the donation must be made exclusively for public purposes.  Any donation to a public entity where the donor receives a quid pro quo from the public entity is not going to meet this standard.  Thus, the question becomes whether a contribution to the Fund can honestly be characterized as a contribution solely for public benefit where the taxpayer is presumably only paying into the fund to receive a dollar-for-dollar deduction for federal income tax purposes.  Indeed, the authors of SB 227 are unabashedly forthcoming that the whole purpose of the bill is to assist California taxpayers in avoiding federal income tax!

Interestingly, proponents of SB 227 rely on previous positions taken by the IRS that appear to support the internal logic of the bill.  Specifically, an IRS Chief Counsel Advice Memorandum from February 2011 (CCA 201105010) provides that the resulting tax benefit received by the taxpayer in exchange for a charitable contribution is not, by itself, a quid pro quo benefit: “the tax benefit of a charitable contribution deduction is not regarded as a return benefit that negates charitable intent [that would lead to] reducing or eliminating the deduction itself.” 

The Memorandum goes on to note that a reduction of federal income tax liability resulting from the receipt of a tax credit following a contribution to a public fund  is not the type of “consideration” that would undermine the charitable nature of the contribution.  When read as a whole, the Memorandum offers two positions that seemingly support SB 227: (1) contributing to a public fund is an accepted form of charitable donation; (2) the tax benefit received by the taxpayer in exchange for the contribution is not a quid pro quo benefit negating the charitable nature of the contribution.

Critics of SB 227 are quick to point out that the Memorandum is not binding precedent and should not be interpreted by taxpayers as the rules under which the IRS must play. Indeed, the Memorandum includes a forewarning that the IRS may, under “unusual circumstances”, disallow certain charitable contributions if they are truly payments in satisfaction of a tax liability. It remains to be seen what the IRS considers to be an unusual circumstance however it is reasonable to assume that it will take the position that SB 227 falls under such category given the expressed intent of the bill.   

As of the writing of this article, SB 227 is still in committee but it seems likely that the bill will be voted on in the next few months. What remains to be seen is whether the California legislature will seek an opinion from the IRS before enacting the law or will simply rely on the Memorandum (notwithstanding its dubious precedential value) and prior case law.  If the latter, before contributing to the Fund and taking the charitable deduction on your 2018 tax return, you should consult with a tax professional to discuss the potential tax complications that may arise should the IRS ultimately conclude that such contributions do not qualify for the charitable deduction.

Daniel Nevis is a partner at the law firm of Miller Morton Caillat & Nevis, LLP, located in San Jose, California.  If you have questions for Daniel about this article, please email him at djn@millermorton.com