IRS Guidance on Tax Reform – Payments Made in Exchange for State and Local Tax Credits
On May 23rd, 2018, the U.S. Department of the Treasury and the Internal Revenue Service (“IRS”) issued Notice 2018-54 (the “Notice”) stating that regulations will be forthcoming that will address the deduction of certain state and local tax payments for federal income tax purposes. Applicable to taxable years beginning after December 31, 2017, and before January 1, 2026, Section 11042 of “The Tax Cuts and Jobs Act,” Pub. L. No. 115-97, limits an individual’s deduction under § 164 for the aggregate amount of state and local taxes paid during the calendar year to $10,000 ($5,000 in the case of a married individual filing a separate return). State and local tax payments in excess of those amounts are not deductible.
Many state legislatures have responded to this new limitation with legislative proposals that would allow taxpayers to make transfers to funds, established and controlled by state or local governments, in exchange for credits against required state or local taxes. These state proposals effectively would allow taxpayers to characterize such transfers as fully deductible charitable contributions for federal income tax purposes, while also utilizing the same transfers to satisfy state or local tax liabilities. In the Notice, the IRS specifies that, 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 proposed regulations will clarify that the requirements of the Internal Revenue Code, as governed by “substance over-form principles”, determine the federal income tax treatment of such transfers, despite any state characterization to the contrary. The proposed regulations will also assist taxpayers in understanding the relationship between the federal charitable contribution deduction and the new statutory limitation on the deduction for state and local tax payments. Finally, the Notice informs taxpayers that the IRS and Department of the Treasury will monitor any forthcoming state legislative proposals to ensure that federal law dictates the characterization of deductions for federal income tax filings.