CHICAGO - In the wake of the new nationwide tax law, states, including Illinois, which are setting up workarounds to state and local tax deducation caps, have been warned by the Internal Revenue Service that federal law controls deductions.
The Tax Cuts and Jobs Act, signed in December, said a taxpayer can only deduct up to $10,000 in state and local taxes paid in each tax year.
However, some legislators, particularly those in states where taxes tend to be higher such as Illinois, New York, California and New Jersey, are considering ways of carving out an end run around the new provisions.
Robert Chase
| Eversheds Sutherland
In Illinois, legislation has been filed to set up the Illinois Excellence Fund. Through that fund, taxpayers would receive a credit in exchange for a contribution. These payments can then be described as charitable contributions, thereby allowing taxpayer to circumvent the $10,000 cap.
In response to such proposals, the IRS issued a notice telling legislators that federal tax law "controls the characterization of the payments for federal income tax purposes, regardless of a state’s characterization of such payments."
Robert Chase, an attorney and tax expert with Eversheds Sutherland, said the IRS notice is directed more at lawmakers than taxpayers.
"I suspect it will mean less for taxpayers and more for legislators," Chase told the Cook County Record.
"Certainly they are the target of the IRS announcement - the legislatures - saying, 'Hey guys, I understand that you want to find a way around the caps that Congress put on the ability of deductibility of state taxes, but this isn't the way to get around that.'"
Chase said he is not sure whether the provisions will be challenged in court, potentially reaching as far as the U.S. Supreme Court. If they are, he said the challenges will take some time.
"What I think is difficult is that a state can pass a law and it can go through, but it would take a while because the states are not challenging the congressional legislation, that it is not legal or unconstitutional. What they are doing is 'We are developing this end run,'" he said.
Chase said any cases would take a long time to develop, as a taxpayer would need "to make a payment under one of these provisions set up by the state, then claim a full deduction for that payment, then the IRS is going to have to audit that taxpayer and deny the deduction, and then it could end up in federal court or tax court."
The reason for the IRS announcement, Chase said, was that the agency believes the states are moving farther than is allowed under federal law to help taxpayers get around the new provisions. Chase said he is not really surprised that state legislators are contemplating action, but the IRS is reminding legislators "that the determination over whether something is a charitable contribution or is a tax is determined under federal law."
"So just because the state says it is a charitable contribution does not make it so for tax purposes," Chase said.
Legislators may come under pressure from taxpayers to reduce state taxes, but practically speaking states will be "hard-pressed" to find an alternative way to fund necessary services, Chase said.