Hemel & Kamin On Treasury's New SALT Regulations

David Kamin (NYU), Treasury’s SALT Regulations:

Treasury recently released regulations targeted at one of the strategies states are using to try to effectively maintain the deductibility of state and local taxes paid byindividuals. The regulations aim to stop states from doing so by creating charitable donation programs. These are programs in which residents give money to certain funds or organizations, take a charitable deduction for their giving, and then receive a tax credit — often nearly a one-for-one credit — reducing their state taxes in return. As a result, non-deductible state and local taxes get replaced by what is ostensibly charitable giving.

Treasury’s proposed regulations aim to stop these maneuvers by applying the quid pro quo doctrine to state and local tax benefits. Where applied (and it is applied inconsistently), the quid pro quo doctrine suggests that the amount of the charitable deduction is the difference between the value of what someone gives to a charity and what they get back in return if anything. It hadn’t previously been extended to state tax benefits, but the proposed regulation does so if those benefits exceed certain de minimis thresholds.

The question then is whether Treasury has the authority to take this action. My view is that it does have the discretion to go in this general direction, despite this representing a significant change in the treatment of state tax benefits. To be sure, the SALT cap is still deeply flawed, but, here, Treasury went in a reasonable direction given the mess it was handed. Key is that Treasury chose to treat the old tax credit programs in often “red” states the same as the new tax credit programs in the “blue” states. The possible alternative of discriminating between the red-state and blue-state programs would likely have been based on arbitrary and capricious reasoning in my view and thus should have been struck down by the courts.

However, Daniel Hemel — my co-contributor to Whatever Source Derived — has raised a possible objection to these proposed regulations. In particular, they treat federal and foreign tax benefits differently from state and local tax benefits; the quid pro quo doctrine apparently isn’t extended to them. While Daniel doesn’t claim this to be an open and shut argument, he suggests that this difference in treatment of tax benefits is plausible grounds for challenging the regulations as exceeding Treasury’s authority.

While a court might buy the logic Daniel lays out, I don’t think it should, certainly when it comes to the federal tax benefits, which are the big deal. In my view, Treasury — if it explains itself — should be on solid ground distinguishing the federal tax benefit from the state and local ones, and not reducing the charitable deduction for the former even as it does for the latter. I agree with Daniel that the treatment of foreign tax benefits under the regulations seems worth revisiting, even as there are some ways to justify the proposed treatment.

Daniel Hemel (Chicago), Secretary Mnuchin’s SALT “Clarification”: A Lesson in Political Geography?:

Tax scholars and practitioners have been scratching their heads over the past few days regarding IRS Notice 2018–78, which purports to clarify the proposed regulations that the IRS issued last month regarding state charitable tax credits. In a press release accompanying the notice this past Wednesday, Treasury Secretary Steven Mnuchin said that “the longstanding rule allowing businesses to deduct payments to charities as business expenses remains unchanged.” Yet as Andy Grewal and others have noted, there is no longstanding rule allowing businesses to deduct payments to charities as business expenses. Rather, longstanding Treasury regulations allow businesses to deduct transfers to charities as business expenses only when those transfers “bear a direct relationship to the taxpayer’s trade or business” and “are made with a reasonable expectation of financial return commensurate with the amount of the transfer.”

If Secretary Mnuchin intends to change that rule — i.e., to allow businesses to deduct payments to charities as business expenses — then state and local governments can make it very easy for individuals with income from “passthroughs” (partnerships and S corporations) to blunt the impact of the December 2017 tax law’s $10,000 cap on state and local tax (SALT) deductions. For example, a state could give partnerships and S corporations a dollar-for-dollar state tax credit for contributions to state-affiliated or state-chosen charities; the partnership or S corporation could claim those contributions as a section 162 business expense, which passes through to the partner or S corporation shareholder; the partnership or S corporation could then pass the state tax credits through to its partners or shareholders; and the partners or shareholders could use those credits to offset their state tax liability. Last month’s proposed regulations — which require individuals to reduce their section 170 charitable contribution deductions by any state tax credit above a de minimis amount — would not get in the way, because the partner or shareholder would never need to claim a section 170 charitable contribution deduction for donations to state tax credit programs. A section 162 business expense deduction would pass through to them, and that would be that.

Alas, this arrangement does nothing to benefit employees who run into the $10,000 SALT cap. That is because the December 2017 tax law also prohibits employees from claiming business expense deductions under section 162. (The suspension of employee business deductions runs out in 2026, which is when the $10,000 SALT cap disappears as well.) So it appears that Secretary Mnuchin has written a playbook for partners and S corporations to escape the effects of the $10,000 SALT cap but left employees high and dry.

This realization led me to ask: Who are the partners and S corporation shareholders who stand to benefit from the IRS’s purported “clarification” (which really looks more like a change in the law)? Or more precisely: Where are they?