Treasury Department warns states over tax law workarounds

The Treasury Department warned states Wednesday to tread carefully as they consider gimmicks to try to let their wealthier taxpayers avoid higher bills under the new federal tax law.

The admonition is aimed at high-tax Democratic-led states who said they were getting socked by the tax changes Republicans pushed through Congress last year.

New York, for example, has tried to allow wealthy residents to pay some of their taxes as a charitable donation, hoping to give them a federal tax write-off to compensate for lower deductions on their property and sales tax.

But Treasury said it’s going to unveil new rules making clear the federal government, not the states, will decide whether those workarounds are valid.

“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 department said in a notice Wednesday.

The $1.5 trillion tax cut reduced rates for most Americans, but also curbed some exemptions and deductions wealthier taxpayers had claimed. One of the biggest limits was imposed on the federal deduction that taxpayers can claim for state and local taxes, such as property or sales levies. Under the new law, taxpayers can only deduct $10,000 worth.

Conservatives argued that allowing people to write off local taxes amounted to a federal subsidy of high-tax states. They said those states should cut rates. New York, New Jersey and Connecticut initially threatened to sue.

Instead, New York approved its charity workaround, allowing residents to make a donation to the state’s education or health funds, then get a credit on their local tax bill. New York argues the donation, meanwhile, will reduce their federal tax bill.

In New Jersey, taxpayers can also get a credit on their property tax bill of up to 90 percent of a donation they make to new charity funds set up by localities or school districts.

Wednesday’s warning suggests the Trump administration is about to push back — drawing cheers from the tax bill’s chief author, Rep. Kevin Brady, Texas Republican and chairman of the Ways and Means Committee.

“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.

But Sen. Robert Menendez, New Jersey Democrat, said it’s “absolutely unacceptable” to use the IRS as a “political weapon” to target residents of his state, saying more than 30 states have implemented similar funds for years.

“The only reasonable conclusion to draw is that the Trump administration will stop at nothing to hurt New Jersey, and will always put petty partisan politics ahead of the people he has been sworn to serve,” Mr. Menendez said.

Jared Walczak of the Tax Foundation, however, says the blue state workarounds were “legally dubious,” and said it was right for Treasury to step in with more guidance.

“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,” Mr. Walczak said.

He said the federal charitable tax deduction is supposed to go to donations made “solely for public purposes” if they’re made to the government. The workaround donations, he said, appear to be primarily geared toward lowering taxes for private individuals.

The Institute on Taxation and Economic Policy, a left-leaning think tank, issued a new report Wednesday warning the Treasury not to single out the blue states, saying if they’re going to tackle charitable donations they could also target private school voucher programs.

“Long before the tax law passed, some states abused the idea of charitable giving to funnel public money to various activities, such as private K-12 education, by reimbursing up to 100 percent of their taxpayers’ donations with tax credits,” said Carl Davis, the group’s research director.

The report also said narrow guidance from the Trump administration would simply create a cascading effect, with state and local officials continually tweaking their funds to stay one step ahead of federal limits.

A better approach would “focus on the real economic impact of so-called ‘charitable gifts’ from the perspective of the donor, and would reserve the deduction only for gifts that involve a genuine financial sacrifice,” the report said. “This approach would be simpler, fairer, and more effective.”