You may never have considered your state government or local school district to be a charity needing your donation, but you might want to start thinking that way if the Republicans follow through on their plans to demolish the traditional federal deduction for state and local taxes.
Or you might want to start thinking of yourself not as a corporate employee, but a small business, or even an actual corporation, to take advantage of new rules and lower tax rates proposed for partnerships and individually owned businesses. These businesses are typically known as “pass-through” firms, because they pay taxes through their individual owners.
That’s just the beginning of the games that government officials, corporations and individual taxpayers will start playing once the remarkably haphazard tax proposals now before Congress take effect, as soon as Jan. 1.
The chaotic gestation of what has been billed as the most significant tax legislation in a generation has left many tax experts appalled. The measure, which Republicans hope to send to the White House for President Trump’s signature by Christmas, bristles with provisions likely to have unexpected or unexplained consequences—unexpected tax increases for some businesses and industries, unheralded tax cuts for favored taxpayers, loopholes begging to be exploited by smart tax lawyers.
In last-minute negotiations, some of the most glaring errors and petty cruelties in the original House and Senate bills have been corrected. A corporate alternative minimum tax that would have negated some favorite business tax breaks reportedly was removed. So were provisions taxing graduate-student tuition waivers, which would made graduate education unaffordable for thousands of students; and repeals of deductions for student-loan interest and high medical expenses. But plenty of loopholes and ill-considered tax hikes remain.
“The amount of ambiguity in this tax bill is amazing,” says Manoj Viswanathan of UC’s Hastings College of the Law.
A digest of the opportunities for gaming the result prepared by 13 academic tax experts, including Viswanathan, hinted at who will benefit from the final legislation.
“Tax lawyers and accountants are already preparing to exploit ambiguous and poorly drafted provisions,” they wrote, predicting that the loopholes would drive up the 10-year cost of the bill far beyond projections exceeding $1 trillion. “We suspect that in the end, the wealthy and well-advised will benefit disproportionately from these errors of oversight and haste.”
For residents of California and other high-service, high-tax states, the big-ticket item in the tax proposals is the cutback on deductions for state and local taxes, known as SALT. Californians account for nearly 20% of all SALT deductions, tops in the nation, although the deduction shelters a larger percentage of income for taxpayers in New York, New Jersey and Connecticut—all Democratic states.
Even though partisan politics may have played a significant role in the GOP’s painting a bull’s-eye on the SALT deduction, the repeal may have even more to do with the legendary remark attributed to bank robber Willie Sutton when asked why he chose them as his target: “That’s where the money is.” The SALT deduction is estimated to cost federal coffers an average $130 billion a year over the next 10 years—more than any tax break except for the exemption for employer-sponsored health plan premiums and the capital gains tax rate.
In the compromise most recently reached by House and Senate Republicans, taxpayers would be able to deduct up to $10,000 in state and local taxes, including property taxes. That’s an improvement over some of the original proposals, which would have wiped out the deductions entirely, but not much of one. The share of California taxpayers facing a tax increase as a result of losing the deduction would fall to between 11% and 12% from 14% under the compromise, according to an estimate by the Institute on Taxation and Economic Policy.
Limiting the SALT deduction could affect as many as 6 million Californians—one of every three taxpaying households in the state, according to Michael Cohen, director of the state Department of Finance. The average deduction for property taxes is about $6,000, he has told the state congressional delegation, and the separate deduction for state and local income taxes comes to nearly $16,000 per return.
One option that could be considered by the Legislature would be to redefine state and local taxes as charitable contributions, which remain fully deductible under the GOP tax proposals. The idea isn’t as implausible as it seems: The Internal Revenue Service and federal courts have ruled that government entities can count as charities for the purpose of the charitable deduction, even when the donor receives a full state or local tax credit in return.
Indeed, legislators in Sacramento already are working on a plan to give taxpayers the option of making charitable deductions to state government and taking a tax credit.
Up to now, the maneuver hasn’t been very important except for high-income taxpayers subject to the federal alternative minimum tax, which disallows the deduction for state and local taxes but allows it for charitable contributions. Fewer than 5% of California taxpayers have been subject to the federal AMT, almost all of them with incomes higher than $200,000.
In a 2013 paper, Kirk J. Stark of UCLA Law School and Phillip Blackman, now of Ithaca College, offered a “thought experiment” in which California established a “state charitable contribution fund” aimed at covering general fund expenditures while offering donors a dollar-for-dollar credit against state taxes. The state would receive the same revenue, but the taxpayer exposed to the AMT would retain the deduction for money voluntarily handed over to the state.
“From the state’s perspective,” Stark and Blackman wrote, “that should be simply an accounting maneuver”; for the taxpayer, it’s money in the bank.
California and other states already have similar systems in place, Stark told me. California’s college access fund grants a 50% state tax credit for contributions to the Cal Grants program, which aids low-income college students. The program, which this year was extended through 2023, hasn’t been especially popular—although a maximum of $500 million in credits is available each year, only $5.4 million was claimed in 2016, the latest year available. That’s probably because the 50% tax credit isn’t very alluring, and only AMT taxpayers would find the credit to be of any use, Stark says.
But 16 other states grant state tax credits for contributions to “scholarship organizations” that often fund private schools as a back-door vehicle for private school vouchers. Those have passed IRS muster.
The rollback of the SALT deduction vastly expands the target population beyond AMT taxpayers while increasing the urgency for state legislators to shelter their revenue from the feds.
“You’re manipulating California’s tax system so that the couple of million itemizers who are going to be hit [by the federal change] would suffer less,” says Darien Schanske of UC Davis Law School, also a contributor to the joint academic paper. The idea would be to provide a state tax credit of up to 100% for contributions to local school districts or even the state general fund.
Because measures such as Proposition 98, which mandates a certain level of spending for schools, and Proposition 13, which limits property taxes, make California’s tax structure so intricate, the change “would be a little complicated but not outside the realm of possibility,” Schanske told me.
Legislators would want to make sure that the new tax structure doesn’t introduce new inequities in state finance—one wouldn’t want USC to receive a windfall in tax-deductible donations while Medi-Cal and state parks are left begging for funds, for example.
Legislators might also want to avoid being too obvious about their intentions, says Viswanathan. “If the state of California were so brazen to say, everyone ‘charitably contributes’ to the state general fund for a dollar-for-dollar reduction in your state income tax, that’s effectively thumbing your nose at the federal government,” he says. “Even though the IRS has blessed this approach, Congress could step in and enact a law saying you can’t do that anymore.”
But there could be other approaches exploiting the loopholes identified by the law professors. Since the congressional tax-drafters still permit businesses to deduct state and local taxes, why shouldn’t they be restructured as payroll taxes payable—and therefore deductible—by employers? Some way would have to be found to make sure employees got the benefit of the employer deduction. In any case, such a change might require a supermajority vote in the Legislature.
Among the only solutions to prevent restructurings to circumvent the SALT reduction, the professors say, is to “reduce or eliminate the cutback” to a degree that reduces the incentive for state-level changes. Short of that, they warn, Congress needs to offer a “realistic” estimate of how much will be gained for the federal budget by the cutback; it’s almost certain to be much less than the congressional GOP claims.