WASHINGTON -- In an unusually blunt notice issued Wednesday, the Internal Revenue Service said it is working on regulations it plans to propose to enforce the new $10,000 cap on the federal deductibility of state and local taxes.

The IRS notice warns that "federal law controls the characterization of the payments for federal income tax purposes regardless of the characterization of the payments under state law."

The outside of the Internal Revenue Service headquarters building in Washington.
The outside of the Internal Revenue Service headquarters building in Washington. Bloomberg News

The announcement comes after New York, New Jersey and Connecticut recently enacted state laws providing a workaround of that annual cap that began Jan. 1 under the Tax Cuts and Jobs Act that was enacted in December.

All three states have created charitable funds into which taxpayers can make contributions to offset a high percentage of their state and local taxes.

California also has workaround legislation that has passed the State Senate and is awaiting action in the State Assembly.

The IRS notice is likely meant to slow the legislative fixes being enacted by states, according to Howard Gleckman, a resident fellow at the Tax Policy Center.

Gleckman said the IRS notice sends a “very strong message that they are not going to look favorably at the charitable workaround.”

“It may mean [that the IRS is] not going to have a formal regulatory response for a while,” Gleckman added, explaining that it might make some state legislatures pause in their rush to enact workarounds.

New York State also enacted a new payroll tax for employers as an alternative workaround. The IRS notice made no mention of it, which Gleckman said may signal the IRS is “less comfortable rejecting that proposal.”

Complicating the IRS’ work is the fact that it and federal courts have previously upheld the legality of smaller scale charitable deductions established by states.

Thirty-three states, including California, previously enacted 113 different tax credits that can be deducted on federal taxes, according to a report issued several months ago by eight law professors.

Most of the earlier state tax credits cover only a fraction of the donations – for instance, 25% or 50% -- but few cover the full amounts.

Among those that do are: a 100% South Carolina tax credit for donations of up to $2 million to the Industry Partnership Fund at the South Carolina Research Authority; a 100% credit in Alabama for up to 50% of a taxpayer’s tax liability for donations to scholarship granting organizations; and two 100% tax credits in Montana for educational donations up to $150 per taxpayer.

New Jersey Gov. Phil Murphy said, “For the federal government to permit certain states to allow for charitable deductions, but not others that are following the same principles, is unconscionable. Once again, President Trump is unfairly targeting the hardworking people of New Jersey.”

The IRS notice said the proposed regulations will address “the federal tax treatment of transfers to funds controlled by state and local governments (or other state-specified transferees) that the transferor can treat in whole or in part as satisfying state and local tax obligations.”

“The proposed regulations will make clear that the requirements of the Internal Revenue Code, informed by substance-over-form principles, govern the tax treatment of such transfers,” the notice said.

House Ways and Means Committee Chairman Kevin Brady, R-Texas, issued a statement applauding the IRS announcement for addressing what he termed as “gimmicks” in which “some politicians are still trying to discredit this new economic momentum in defense of high taxes and stagnant growth.”

The lawmakers who authored the tax law changes have emphasized that most households who have claimed a deduction for state and local taxes in the past won’t need to itemize it going forward because the standard deduction has been doubled to $24,000 for couples and $12,000 for individuals.

“There are many mayors and governors who do a good job of balancing budgets and creating jobs in their communities without high taxes,” Brady said. “And I encourage those few states that are trying to undermine our growing economy to instead focus on how they can lower their own taxes on their constituents and keep moving our economy forward.”

A report issued on May 7 by S&P Global shows that the impact of the new $10,000 SALT cap is concentrated at the county level in large areas of coastal California, Washington D.C., and greater New York City, which includes parts of Connecticut and northern New Jersey.

But 60% of the 117 counties that S&P found to be most affected by the SALT cap are in 20 states outside of New York, New Jersey and California.

Five counties in Kentucky – Boone, Campbell, Fayette, Oldham and Woodford – are included on the list. Wisconsin also has five at-risk counties while Oregon has six and Iowa has two.

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