Tax cap relief bill at odds with IRS

Legislature’s effort to get around state deduction limits in doubt because of new federal guidelines

SACRAMENTO >> If Gov. Jerry Brown signs a bill designed to ease a new federal $10,000 cap on state and local tax deductions, California will be the latest blue state to try to outmaneuver the unpopular change made as part of last year’s tax overhaul.

But California’s plan — watched closely by homeowners and others who itemize in the high-tax state — is in deep doubt now that the IRS has laid out new draft regulations revealing exactly how it plans to scuttle attempts to get around the new rules.

Awaiting Brown’s signature or veto is Senate Bill 539 from state Sen. Kevin de León, a Los

Angeles Democrat who also is running for U.S. Senate. SB 539 would expand an existing taxcredit program for those who give to Cal Grant college scholarships, raising the value of the state credits from 50 percent to 75 percent of each dollar contributed, among other changes. It sailed through the Legislature on Friday with broad bipartisan support. Brown has until Sept. 30 to sign it into law.

The general idea behind this and other taxcap workaround plans is that taxpayers could donate to a fund, get most of the money back in the form of state tax credits, and still claim the full amount as a charitable contribution — a federal deduction that is not subject to a new cap.

Say you previously deducted $18,000 in state

and local taxes — the average in California for those who itemize — but now you can only claim $10,000 because of the cap. If you wrote an $8,000 check to a special fund, you’d get a large percentage of that money back — 75 percent, or $6,000, under SB 539 — as a state tax credit. Then comes the workaround: Even though you really only gave $2,000, you would claim the entire $8,000 as a charitable contribution and, in theory, be made almost whole.

Under proposed IRS regulations issued last week, however, that same donor could only claim $2,000 as a deduction — the contribution minus the state tax benefit. The proposed rules, as written, specifically apply to all state tax-credit programs, even those in place before the federal tax overhaul.

To many, including experts at the Washington, D.C.-based Tax Foundation, the flurry of proposed end-runs around the new cap always sounded too good to be true, even though states of all political stripes have used the same approach to funnel resources into private school vouchers, college scholarships or conservation easements.

The new regulations appear to validate such skepticism.

Late last week, just days after the IRS development, the California lawmaker behind a similar proposal — Assembly Bill 2217 — pulled her bill.

“I introduced AB 2217 to protect California’s taxpayers and to support nonprofits and schools, which are most threatened by the president’s misguided agenda,” said Assemblywoman Autumn Burke, D-Inglewood, in a statement. “However this latest IRS ruling only adds to the confusion taxpayers are already experiencing as they navigate these changes.”

One expert who has been following the workaround proposals closely noted that the IRS still must justify the change if the regulations are challenged in tax court. If it fails to do so, plans from blue states such as California, New Jersey and New York might still have a shot.

“Even though it’s an uphill battle, it’s not necessarily an impossible battle,” said Professor Darien Shanske, who teaches tax law at UC Davis.

Another possibility, Shanske said, is that IRS changes its draft regulations under pressure from red states such as Alabama and Florida to protect their private-school voucher programs. If the agency makes an exception for some tax-credit programs but not others, he said, that could weaken the agency’s case in court.

If, for example, the IRS decided to give different treatment to state taxcredit programs benefiting private schools and funds directed to public schools and scholarships, Shanske said, “(SB) 539 would be a wonderful example to go into court with.”

“Even though it’s an uphill battle, it’s not necessarily an impossible battle.” — Professor Darien Shanske, UC Davis