Treasury Issues Crackdown on State and Local Tax Workarounds

Treasury Issues Crackdown on State and Local Tax Workarounds

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Some analysts had expected the Trump administration to try to carve out an exemption for pre-existing programs like Alabama’s, which are more common in Republican-leaning states. But by choosing not to do so, the administration may have made the new policy easier to defend.

Darien Shanske, a law professor at the University of California, Davis, said the government had “taken the more principled approach” by going after all the programs, not just newly adopted ones like New York’s. Still, Mr. Shanske said the government would need to explain why it was moving to block state efforts now when it hadn’t acted earlier.

“I think states will have the grounds to challenge it,” he said. “You need to explain why you’re turning practice on its head.”

But Jared Walczak, a policy analyst for the Tax Foundation, said the new tax law changed the stakes for the I.R.S. For one thing, the previously unlimited deduction for state and local taxes meant that for most taxpayers, the state-level charitable credits had no effect on taxpayers’ federal tax liability. With the deduction capped, that will no longer be true.

A wealthy taxpayer who contributes $10,000 to a private school scholarship fund in Iowa, for example, receives a $6,500 tax credit from the state, under Iowa law. Previously, the taxpayer could deduct that entire $10,000 contribution from her federal taxes. Under the new regulation, she would only be allowed to deduct $3,500.

And the newly adopted programs are on a much larger scale.

“The simple answer is it just never rose to the level of importance where the I.R.S. chose to weigh in,” Mr. Walczak said.

Treasury officials said the rule would stand up to challenges because it applies a longstanding principle of taxation, known as “quid pro quo” doctrine. That principle prevents taxpayers from deducting contributions to charity that pay for a good or service. For example, someone who pays $1,000 at a charity auction for a painting valued at $750 may only deduct $250 from her federal taxes.

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