The Internal Revenue Service issued new regulations late last month in an effort to end workarounds by blue states hoping to bypass the state and local tax deduction cap introduced under December's federal tax overhaul. But observers say that even with the new regulations, states still have several ways to get around the cap.

So far, Connecticut, New Jersey, New York and Oregon have passed laws that would allow residents who owe more than $10,000 in state and local taxes to pay the remainder into a state or local charitable trust, which is still deductible under federal law. Similar proposals are pending in California and Illinois.

Residents in the above states who itemize their taxes average far more in state and local tax deductions than the new federal cap. As such, states with high taxes have an interest in protecting their rates by making sure their residents can lower their federal tax burden by still deducting those taxes from their income.

Last month, however, the IRS targeted those efforts with what it said were "proposed regulations [to] substantially diminish this incentive to engage in socially wasteful tax-avoidance behavior." The new rules, which are now open for comment, would require taxpayers to reduce any federal charitable tax deduction they are claiming by the amount of any good or service they receive. Because these state programs are offering a tax credit in exchange for the charitable donation, the rules effectively prevent taxpayers from circumventing the cap.

But according to tax experts, states could still work around the cap in other ways.

Rework Their Charitable Loophole

 

While the IRS is within its right to change regulations, there's one big problem with these: They change the rules for the more than 100 quasi-government charities in 30 states that have long allowed taxpayers to lower their tax burdens by making contributions in exchange for things like school vouchers, tuition scholarships and conservation easements.

Previous IRS guidance, most recently in 2010, has supported this practice. Associations that represent nonprofits and charities, such as the Philanthropy Roundtable, are pushing back on the IRS to create a carve out for "legitimate charitable programs."

If the feds do bend to the pressure, says the Institute on Taxation and Economic Policy's Carl Davis, it opens up an avenue for states to enact a tax credit program that fits within whatever exceptions the IRS makes.

But, Davis adds, the IRS is likely keen to avoid that loophole. "I think a big part of the reason they have broadly applied this is they know if they create any carve out at all," he says, "states will be taking a close look at how to shoehorn themselves in to whatever gap they create."

Await a Ruling on a Pending Lawsuit

 

If the rules stand, they could still be useful to states that are suing the federal government over the state and local tax deduction cap.

In the suit, filed in July, Connecticut, Maryland, New Jersey and New York argue that the cap violates the U.S. Constitution's Equal Protection Clause and the 10th Amendment, which protects states' rights. The suit accuses the federal government of meddling in state taxation and fiscal policies by making it more politically difficult for states to raise revenue if needed.

Many experts have said that the suit is a longshot. But the IRS may have unwittingly buoyed states' claims, says Jim Malatras, president of the Rockefeller Institute of Government. That's because, in targeting action to certain state responses to federal law, the IRS is "picking winners and losers within states that have constitutionally passed their own laws."

Institute a Payroll Tax

 

Beyond the charitable deduction tactic, states have other options. But politically, they're more difficult.

For starters, the cap is temporary. Some argue that states could simply wait until 2025, when the cap is scheduled to sunset, and hope that by then the politics will have shifted and support for keeping the cap will have subsided.

More immediately, though, states could increase business taxes, which are still deductible under federal law. So, according to a paper published by more than a dozen tax scholars and analysts, instead of workers paying state income taxes, employers could take the equivalent amount of money out of a worker's wages. Businesses would then pay a payroll tax on those lower wages and deduct it from their federal taxes. The employee would have a lower income to declare to the IRS and would effectively receive the same take-home pay while saving the same amount on taxes as they did under the old system.

That's what New York state has come up with. Connecticut has also implemented a similar tax-shifting system for LLCs, which are business that file taxes as individuals.

The problem is that these changes require a lot more education and buy-in. Getting a credit for a charitable payment is one thing to a taxpayer. Accepting a lower salary is another. "I do think if those same taxpayers are going to continuously feel the pinch," says Malatras, "they may become more open to it. The question is, what's the tipping point?"

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