By. Susan Shelley originally published for Fox & Hound
Unless California is trying to break the Guinness World Record for tax evasion, it’s hard to see what will be accomplished by the plan put forward by Senate Leader Kevin de León to get around the new federal tax law’s limitation on the deduction for state and local taxes.
“This is legal,” de León insisted, and he could be right, right now. But there is plenty of evidence to suggest that he won’t be right for very long.
The plan, now introduced in the state Senate as Senate Bill 227, would create something called the California Excellence Fund within the state’s General Fund, and if taxpayers chose to make donations to that special fund, they would receive a credit against their state income tax liability equal to the amount of their donation.
The state would end up with the same amount of revenue, but the taxpayer would be better off because donations to the California Excellence Fund would be considered charitable contributions, deductible on federal tax returns. This would get around the new $10,000 limit on the deduction for state taxes.
De León’s contention that this is legal is based on an Internal Revenue Service Chief Counsel Advice Memo from February, 2011. CCA 201105010 states that the payment of cash to a state agency that creates a tax benefit is “not regarded as a return benefit that negates charitable intent.” So it’s an allowable charitable deduction.
However, the CCA memo also warns, “there may be unusual circumstances in which it would be appropriate to recharacterize a payment of cash or property that was, in form, a charitable contribution as, in substance, a satisfaction of tax liability.” In other words, the IRS reserves the right to disallow the deduction in “unusual circumstances.” Possibly one such circumstance would be the entire state of California trying to evade federal taxes at the same time.
Even if the IRS went along with it, Congress could easily change the law and limit or end the deductibility of donations to special funds with a state tax-credit connection.
Here’s where the intrigue begins.
Seventeen states currently offer state tax credits for donations to nonprofit organizations that provide vouchers for private schools. This gets around any prohibition on using public funds for private schools, especially religious private schools.
One of two things will likely happen as a result of de León’s proposal, should it become law: California will get away with it, because Congress doesn’t want to undermine the tax-credit scholarship funds in other states, or Congress will ban the tax-credit deduction entirely and California will have ruined it for everybody.
It’s always more interesting than it first appears, isn’t it?
The Institute on Taxation and Economic Policy estimated that the state tax credits for the voucher programs total $1 billion per year. In some cases, taxpayers can collect more in tax benefits than they donated.
Last summer, the Trump administration was reported to be considering expanding the tax-credit scholarship idea into a nationwide program. “It’s certainly part of our discussion,” Education Secretary Betsy DeVos told the Associated Press in August.
Of course, the public education establishment opposes taxpayer-funded vouchers for private schools, but there wasn’t much they could do about it. The courts upheld the tax-credit arrangement as legal.
It’s an understatement to say the public education lobby is very powerful in Sacramento. Are they cheering on de León’s proposal, waiting in the wings with their legal teams to argue that if California’s tax-credit-charitable-deduction plan is disallowed, all those tax-credit scholarship funds for private schools have to go, too?
Maybe Congress can thread the needle in a way that preserves the state tax-credit charitable deduction for school vouchers while banning California’s scheme to push all state tax payments through the same loophole. But before that happens, the IRS will probably send out a new CCA memo and start disallowing the deduction for “donations” of state tax payments in California.
The whole mess is likely headed for court, giving California politicians many months or years to posture and rant about “resistance.” Meanwhile, beleaguered taxpayers continue to suffer under the highest state taxes in the country, and all state lawmakers are doing about it is giving them sketchy tax advice.