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<i>The Week in Public Finance:</i> Can the IRS Stop States' Tax Reform Workarounds?

The IRS wants to thwart state efforts to avoid the new cap on state and local tax deductions. It's unclear whether that would be legal -- or effective.

Now that three states have created workarounds to a part of last year's federal tax overhaul, the Internal Revenue Service (IRS) is trying to stop others from following.

Last week, the IRS announced that it would propose regulations that address attempts by states to help their residents avoid the new federal cap on state and local tax deductions. So far, California, New Jersey and New York are nearing passage of laws that would allow residents who owe more than $10,000 in state and local taxes to pay the remainder into a state charitable trust. Because charitable contributions are still tax-deductible under federal law, the state trust contribution offers residents a workaround.

It’s no surprise, says Jared Walczak, a senior analyst at the conservative-leaning Tax Foundation, that the IRS is striking back. “The IRS was never going to be fooled by these workarounds."

But whether the agency can legally thwart such efforts is a point of debate.

Walczak argues that the agency has both caselaw and “substantial leeway” on its side, including the U.S. Supreme Court’s so-called substance-over-form doctrine. That doctine states that for federal tax purposes, a taxpayer is bound by the economic substance of a transaction -- even if the transaction itself varies in its legal form. In other words, “if a payment is made regarding tax liability,” Walczak says, “it doesn’t matter what you call it, you’re paying state taxes.”

Others, however, question the effectiveness of the agency's targeted approach.

There are other ways to respond and work around the cap, says Indiana University tax law scholar David Gamage, who co-authored a paper on the topic. Some states, such as New York, are considering increasing payroll taxes, which are paid by the employer but have unlimited deductibility. The proposed regulations make no mention of these other efforts. “In the long run,” Gamage says, “the IRS doesn’t have the power to shut down everything that would be described as a workaround.”

Meanwhile, there’s concern that the proposed IRS regulations could inadvertently affect the large number of state agencies with a charitable arm. Taxpayers have long been able to make a tax-deductible contribution to these quasi-government causes. For example, Maryland and Massachusetts have environmental trusts run by a state agency. And many conservative states offer school voucher tax credits, a dollar-for-dollar tax cut for donations to a nonprofit that gives out the vouchers.

The existing practice -- which served as a precedent for blue-state lawmakers to cite when approving the workarounds -- creates a sticky situation for the IRS. “It might be possible to craft a rule that has exceptions for the prior structure and simply shuts down what New York has done,” says Gamage. “But that would just be an invitation for New York to change its rule to meet the new guidance.”

If the new regulations are broad and also impact the full deductibility of existing quasi-government charities, it will almost certainly invite a lawsuit. But Walczak says that might just delay the inevitable. “It’s politically valuable for some states to be seen fighting this as long as they can,” he says. “That doesn’t increase their chances of success.”


In other public finance news this week:

Themes From 'State of the City' Addresses

As more people struggle to find affordable housing, the issue is garnering more of mayors' attention. According to the National League of Cities’ annual analysis of 160 State of the City addresses, housing ranked among the top four priorities, alongside mainstays like economic development, infrastructure and the budget.

“Cities are recognizing how to manage their housing supply to create more demand and to alter the overall housing dynamic for the good,” the report says, adding that mixed-use development appears to be “key to that discussion.”

The report also found three emerging trends common to municipalities across the country: the opioid crisis, addressing and preparing for climate change, and expanding broadband access.


Splitting Up In Georgia

At a time when many municipalities are talking about consolidating services, one city in Georgia is going the other way. This month, Gov. Nathan Deal signed a bill allowing the first-ever de-annexation in the state, which will create a new 17,000-resident town called Eagle’s Landing. The move peals off about 9,000 residents from neighboring Stockbridge but leaves the latter with all of the joint debt.

While the move makes sense aesthetically -- on a map Stockbridge looks like a Rorschach ink blot test -- the loss is likely to put a strain on finances. It’s also raised some red flags because of the change in debt situation for Stockbridge. While it’s common for new cities to incorporate, the creation of Eagle’s Landing is unique because it is leaving a neighboring city with a smaller tax base with which to pay off its debt. That, S&P Global Ratings said this week, could result in as much as a 57 percent drop in revenue and create challenges in reducing expenditures while still managing to effectively serve the remainder of the city.

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CORRECTION: A previous version of this mistakenly stated that California, New York and New Jersey have finalized their workaround laws.

Liz Farmer, a former Governing staff writer covering fiscal policy, helps lead the Pew Charitable Trusts’ state fiscal health project’s Fiscal 50 online resource.
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