IRS moves to block California and other states from helping residents avoid new tax-deduction limit

President Trump signs the $1.5-trillion tax cut bill in December. (Mike Theiler/CNP / TNS)

The Trump administration has delivered another blow to California.

The Internal Revenue Service and Treasury Department on Thursday moved to block efforts by lawmakers in California and other Democratic-controlled states to help their residents avoid a new limit on state and local tax deductions.

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The proposed rule, which is likely to face legal challenges, targets legislation in those states that would allow taxpayers to claim a charitable deduction for state and local tax payments above the $10,000 limit set in the tax cuts passed by Congress last year.

The Treasury Department said the legislation being considered in various states amounts to a tax dodge for wealthier Americans.

“Congress limited the deduction for state and local taxes that predominantly benefited high-income earners to help pay for major tax cuts for American families,” Treasury Secretary Steven T. Mnuchin said.

“The proposed rule will uphold that limitation by preventing attempts to convert tax payments into charitable contributions,” he said.

However, the limits on state and local tax deductions will hit some middle-class families in California hard even though the wealthy reap the most benefits from it.

Some 6.1 million California residents filed for the deduction in 2015, reducing their federal taxable income by $18,438 on average, according to the Tax Policy Center. Only New York and Connecticut had a higher average deduction.

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The IRS will accept comments on the rule through Oct. 11 and then will hold a required public hearing on it Nov. 5. The rule is likely to be in place by the end of the year.

Thursday’s announcement escalated a partisan battle over the tax-cut law that was pushed through by President Trump and congressional Republicans with no Democratic support.

California and New York are among the states that have taken action or have been looking for ways around the limit on state and local tax deductions that Republicans included in the $1.5-trillion tax-cut law 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.

“In the Trump administration’s rush to punish California they’re now attempting to unilaterally rewrite the law in a manner beyond their authority, and California is prepared to litigate to protect our taxpayers who were unfairly targeted in the GOP tax plan,” said state Sen. Kevin de León (D-Los Angeles), who has been pushing workaround legislation.

New York Gov. Andrew Cuomo, a Democrat, also slammed the IRS for what he called “hastily proposing politically motivated regulations” that amounted to “abuse of government power.”

“We are confident that the recently enacted opportunities for charitable contributions to New York state and local governments are consistent with federal law and follow well-established precedent,” Cuomo said. “And make no mistake: We will use every tool at our disposal, including litigation, to fight back."

Jared Walczak, a senior policy analyst at the conservative-leaning Tax Foundation, said states were likely to sue but such efforts are “probably futile given the authority the government has in such matters.”

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“The goal of the charitable deduction has always been to give preferential treatment to actual charitable contributions, with guardrails designed to limit its use as a tax-avoidance strategy,” Walczak said.

Legislation pending in Sacramento from De León would allow California residents to circumvent the new $10,000 deduction limit through a 75% tax credit to an existing state program that funds college tuition scholarships.

Assemblywoman Autumn Burke (D-Marina del Rey) has a pending bill that would allow Californians to donate to nonprofits, universities, community colleges or K-12 public school districts, and those entities would transfer 90% of that donation to the state. In turn, the state would lower a taxpayer’s state income tax liability by issuing a state tax credit equal to 80% of the original donation.

Under the bill, California taxpayers would have been able to deduct the entire amount of the contribution as a charitable contribution on their federal taxes.

The bill faces a deadline of next Friday to pass both houses of the Legislature. Gov. Jerry Brown opposed a prior version of Burke's bill because it could disrupt the state's cash flow and questioned the wisdom of acting when the IRS could move to clamp down on such efforts.

The Treasury rule released Thursday would require taxpayers to reduce the federal charitable tax deduction they are claiming by the amount of any credit they receive on their state and local taxes. That would effectively prevent taxpayers from substantively circumventing the cap through the workaround programs.

For example, if a state granted a $700 tax credit on a $1,000 contribution, the taxpayer would be able to write off only $300 on his or her federal return.

The new rule also would hit some existing, limited programs in dozens of states that offer federal charitable deductions for contributions to fund schools and other programs.

Normally, the amount a taxpayer can claim for a charitable contribution must take into account the value of anything received in exchange for the contribution. That previously had applied only to tangible items, such as the value of a free tote bag given for a contribution to a public radio station, or the value of the meal at a charity dinner.

The IRS had not required people to take into account the value of a charitable deduction in lowering their tax liability. Now, the IRS is extending that doctrine to the value of a lower tax liability. An exception in the rule is for tax credits worth no more than 15% of the contribution.

The new restrictions on the previously unlimited federal state and local tax deduction is projected to 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.

Rep. Kevin Brady (R-Texas), a lead author of the tax bill, cheered the new rule.

“These Treasury regulations rightly close the door on improper tax evasion schemes conjured up by state and local politicians who insist on brutally taxing local families and businesses,” he said.

Eight tax experts released a 44-page research paper in January arguing that California and other states would be allowed to turn state and local tax payments into charitable contributions based on previous IRS rulings and court opinions.

Some tax law experts also have said that it would be very difficult for the IRS to prohibit efforts designed to circumvent the state and local tax deduction limit without also disallowing the federal tax deduction for contributions to more than 100 existing charitable programs in 33 states.

Those programs, many of them in Republican-controlled states, fund state-supported activities such as public schools and college scholarship programs.

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The Treasury Department said Thursday that it expected some spillover effect on those other programs, but that only about 1% of taxpayers would see an effect on tax benefits for donations to school tax credit programs.

Times staff writer Liam Dillon contributed to this report.

4:55 p.m.: This article was updated with comments from California state Sen. Kevin de León, New York Gov. Andrew Cuomo and Tax Foundation analyst Jared Walczak, as well as additional details and analysis regarding the IRS rule.

This article was published at 2:35 p.m.

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