Wednesday, January 10, 2018

A better way to explain the introduction of credits against states' income taxes to serve charitable objectives

There has been a whole lot of talk recently (from me as well as others) concerning how state and local governments should respond to the drastic curtailment of federal income tax deductibility for state and local income and property taxes.

One theme that has emerged is that states can encourage charitable giving by taxpayers, to causes that the states will help fund, in lieu of direct state and local tax deductibility. E.g., taxpayers can give donations to state entities, perhaps serving particular purposes, that are creditable (in whole or large part) against, say, one's state income tax liability.

It occurs to me that proponents of examining this response (including me) have at times not been charitable enough to themselves regarding how this effort should be described.

Suppose a state offers 95% credits against state income tax liability, for contributions to state-run charitable entities that serve broad "silos" that are dedicated to different purposes - healthcare, housing, education, infrastructure, public safety, etc. And suppose the amounts are indeed dedicated, such as via a "trust fund" methodology, to the indicated purposes, although annual spending levels may be constrained to, say, 100% or 105% of the amount the legislature had separately designated for spending in the areas that these silos represent.

As I and others have been discussing, there is a risk of the IRS making "substance over form" challenges to these efforts, under the view that the state-creditable charitable contributions are "really" just re-labeled state and local tax payments.

But consider Point #1: If you build enough economic substance into it, it works. The analogy to economic substance in business deals is important, because there one typically has to have a pretax profit motive and business purpose. Here, we are talking about what people want to do about issues that they care about from a charitable standpoint. So just as in the famous Learned Hand quote about no one having an obligation to pay more federal income tax than is due, here it's okay that one was mindful of the federal income tax benefits of doing it this way, so long as there was indeed charitable purpose and charitable substance to what the taxpayer did. (Meaning here the donor, but he or she will be responding to the institutional setup that the state government has decided to offer.)

Then there is Point #2: There is absolutely no reason to think of this as trying to end-run the limit on state and local tax deductibility. Rather, it is about serving the objectives that were previously served by tax-funded state and local government spending. It's about advancing healthcare, public safety, education, etcetera, via the best mechanisms available, which is partly a function of how Congress has decided to structure federal income tax deductibility.

If (1) Congress decides to continue granting deductions for charitable contributions that advance public goals, but to limit state and local income tax deductions (above the $10K level) that could fund spending advancing the same goals, and (2) states and individuals restructure so that they are now doing things the way that Congress apparently likes, rather than the way that it apparently (at least relatively) dislikes, they aren't avoiding Congressional intent - they are fulfilling it.

To say that one was just looking for end runs would be both inaccurate and unfair to the actual motivations that are at work.  What's really at issue here is the underlying objectives (healthcare, public safety, infrastructure, income support, etcetera). It is not the use of one means versus another as an end in itself. What Congress has addressed is the use of one means versus another, and proponents of restructuring state charitable credits are taking it at its word, and seeking to do what it has encouraged them to do, in the way that it has encouraged them to do it.



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