All posts by Janet Byrd

A better way to explain the introduction of credits against states’ income taxes to serve charitable objectives

There has been a whole lot of talk recently (from me as well as others) concerning how state and local governments should respond to the drastic curtailment of federal income tax deductibility for state and local income and property taxes.

One theme that has emerged is that states can encourage charitable giving by taxpayers, to causes that the states will help fund, in lieu of direct state and local tax deductibility. E.g., taxpayers can give donations to state entities, perhaps serving particular purposes, that are creditable (in whole or large part) against, say, one’s state income tax liability.

It occurs to me that proponents of examining this response (including me) have at times not been charitable enough to themselves regarding how this effort should be described.

Suppose a state offers 95% credits against state income tax liability, for contributions to state-run charitable entities that serve broad “silos” that are dedicated to different purposes – healthcare, housing, education, infrastructure, public safety, etc. And suppose the amounts are indeed dedicated, such as via a “trust fund” methodology, to the indicated purposes, although annual spending levels may be constrained to, say, 100% or 105% of the amount the legislature had separately designated for spending in the areas that these silos represent.

As I and others have been discussing, there is a risk of the IRS making “substance over form” challenges to these efforts, under the view that the state-creditable charitable contributions are “really” just re-labeled state and local tax payments.

But consider Point #1: If you build enough economic substance into it, it works. The analogy to economic substance in business deals is important, because there one typically has to have a pretax profit motive and business purpose. Here, we are talking about what people want to do about issues that they care about from a charitable standpoint. So just as in the famous Learned Hand quote about no one having an obligation to pay more federal income tax than is due, here it’s okay that one was mindful of the federal income tax benefits of doing it this way, so long as there was indeed charitable purpose and charitable substance to what the taxpayer did. (Meaning here the donor, but he or she will be responding to the institutional setup that the state government has decided to offer.)

Then there is Point #2: There is absolutely no reason to think of this as trying to end-run the limit on state and local tax deductibility. Rather, it is about serving the objectives that were previously served by tax-funded state and local government spending. It’s about advancing healthcare, public safety, education, etcetera, via the best mechanisms available, which is partly a function of how Congress has decided to structure federal income tax deductibility.

If (1) Congress decides to continue granting deductions for charitable contributions that advance public goals, but to limit state and local income tax deductions (above the $10K level) that could fund spending advancing the same goals, and (2) states and individuals restructure so that they are now doing things the way that Congress apparently likes, rather than the way that it apparently (at least relatively) dislikes, they aren’t avoiding Congressional intent – they are fulfilling it.

To say that one was just looking for end runs would be both inaccurate and unfair to the actual motivations that are at work.  What’s really at issue here is the underlying objectives (healthcare, public safety, infrastructure, income support, etcetera). It is not the use of one means versus another as an end in itself. What Congress has addressed is the use of one means versus another, and proponents of restructuring state charitable credits are taking it at its word, and seeking to do what it has encouraged them to do, in the way that it has encouraged them to do it.

Restoring state and local tax deductibility through self-help

Eight eminent tax law professors have coauthored an important new SSRN piece entitled “Federal Income Tax Treatment of Charitable Contributions Entitling Donor to a State Tax Credit.” It’s available here.

Just for the record, as all are good friends and outstanding members of the field, they are: Joe Bankman, David Gamage, Jacob Goldin, Daniel Hemel, Darien Shanske, Kirk Stark, Dennis Ventry, and Manoj Viswanathan.

The piece addresses the issue of what state governments can do to address the repeal of state and local income and property tax deductibility by individuals above the first $10,000. Plus, it addresses whether the federal government should respond, either administratively or legislatively, to such state government responses.

In particular, the question presented is whether states can tax-effectively rely on charitable contribution credits against state tax liability, and thereby permit their own taxpayers who take advantage to claim federal charitable deductions.

To illustrate the basic idea, suppose I would pay New York State (and New York City) $100,000 of income taxes if I did nothing differently in the future than I have in the past. But now suppose that I can reduce my New York State and City income tax liability, dollar-for-dollar, by making charitable contributions to designated state and local government entities. E.g., I give $90,000 in such contributions, and thereby reduce my remaining liability to $10,000 that falls within the deduction limit.

For this to offer maximum benefit, the income taxes would need to be provide 100% credits against such liability for particular donations. There are already some such provisions in existing state and local income tax law, however, as the article documents in its appendix. And these have generally been held, by case law and/or administrative rulings (with and without express precedential effect), to work for federal income tax purposes. That is, one gets the full charitable deductions contribution for the amount one paid that was 100% creditable against state and/or local income tax liability.

There are two main legal obstacles to success of this gambit under federal income tax law.* The first is allowance of the full federal charitable deduction despite any issue regarding the state tax law benefit that one garnered by reason of making the charitable contribution. By analogy, suppose I gave $100 to NPR and got a bookbag that is worth $20. Then my federal charitable deduction would be limited to $80, i.e., to the gift minus the offsetting benefit. So legal question #1 in the above scenario is whether my federal charitable deduction would be offset by the value of the state income tax saving.

The second main federal legal obstacle to success is substance over form doctrine. Am I actually, in substance as this question is analyzed for federal income tax purposes, making a charitable contribution, rather than simply relabeling my state income tax liability?

The first main point that the article makes is that current legal authority, both from cases and IRS administrative pronouncements, strongly supports what it calls the “Full Deduction Rule.”  This rule holds that “the amount of the donor’s charitable contribution is not reduced by the value of state tax benefits.” In short, legal obstacle #1 as described above should not prevent the relabeling from working.  As a matter of formal legal analysis, the main point here is that the state and local income tax liability doesn’t actually exist until one fully applies the pertinent law. So the fact that the income tax liability never arose, due to the credit, means that there was no legally cognizable benefit. Again, the article shows that this line of reasoning has repeatedly been upheld.

The second main point that the article makes is that there are good policy rationales in favor of continuing to allow the Full Deduction Rule to apply. E.g., does one draw the line at 100% credits? Should charitable deductions generally be reduced for the value of state and local charitable deductions? Must taxpayers always compute alternative state liabilities with and without the credits? Etc.  Plus, the article argues that the Full Deduction Rule serves important federalism values and is consistent with decades of federal tax policymaking. Hence, “Congress should tread carefully if it seeks to alter the Full Deduction Rule by statute.”

I find these arguments convincing. But there is still the issue, not addressed by the article as it would require a much longer and largely distinct analysis, of the circumstances in which 100% (or lesser) credits against state and local income tax liability, for charitable contributions to particular state entities, would have economic substance.

Here is a preliminary thought of mine regarding one way of establishing the requisite economic substance. Key word here is preliminary: A lot of people need to weigh in on this, regarding both federal income tax law and state and local government practicalities.

Suppose a state government offers large buckets to which one can charitably designate one’s charitable contributions that generate a 100% credit against the tax liability. E.g., Medicaid and Public Health; Schools; Infrastructure, etc. Suppose there were 4 or 5 buckets and that one could get a 100% credit for up to X% of one’s state income tax liability by making such designated contributions, but that no more than Y% could go to any one bucket.

The state government would still determine overall annual spending in each category, which wouldn’t be directly affected by taxpayers’ charitable contribution designations. (NOTE – these contributions probably should be required to be paid separately and prior to the state tax itself – not by designation on the state income tax return.)

So where’s the economic substance? Point #1, I get to decide where “my” dollars, as opposed to someone else’s, go. Many people actually care about this, as a matter of subjective psychological fact.

But what if the designations to a given category exceed what the state wants to spend on that category? Simple. The state designates those extra $$ as notionally in a “trust fund” that it currently pledges WILL be spent on that budgetary purpose in the future. Consider the analogy to the Social Security Trust Fund. My FICA payroll taxes ostensibly “will” be spent at some point on paying Social Security benefits. Now, budget aficionados may think this doesn’t really mean much. But actual voters and taxpayers, and perhaps even the U.S. Congress, actually do think it matters. So who are we to second-guess them? (Especially as they may be correct in the sense of the Trust Fund’s affecting likely future political outcomes.)

Hence we get Point #2 for economic substance. My, say, Medicaid-designated contributions WILL, the state now pledges, be spent on Medicaid or other public health either this year in the future. A trust fund pre-commits them to be spent in this way. Sure, the state could change the law next year and take back the promise without recourse on the donor’s part. But, just as in the case of the Social Security Trust Fund, the donor gets the benefit of the political force, if any, that the designation might have in the future. Plus, the state legislators are getting what they might deem valuable information about taxpayer sentiment.

Do others agree with the economic substance analysis that I offer here? Are there other features that they’d deem important? Can states make this workable for themselves and their taxpayers, without undue inconvenience on either side? I am hoping that others will address these issues as well.
* Extra challenges may arise making this practically workable in the case of (a) local as well as state income tax liability, and (b) property taxes that often are paid to a smallish local government unit.

Fun for the holidays?

Despite my often writing articles and even a book about international tax policy, I’ve been a bit remiss so far in my degree of focus on the international rules in the tax bill. They’re complicated and so is thinking about them, I wanted to make sure they were final so I wouldn’t waste time on proposals that disappear, and I’ve been focusing on other aspects such as the passthrough rules.

Plus, I have other academic writing interests that, at the moment, grab me a bit more. My book about literature and high-end inequality is # 1 in this regard, but I’m also writing a short paper about the destination-based cash flow tax on a short time fuse.

That paper will be based on the various versions of slides that I’ve posted in the past, such as here, but it will be much more focused on the academic literature than on last year’s Republican House proposal, which I would presume is politically dead. My main point is that academics should move on from it, too – it’s a multi-instrument package, and each of the instruments is worth taking seriously, but the packaging serves no good purpose and should be dropped, as it only confuses even experts who should know better.

A couple of months ago, I wrote a first draft of a short international tax paper, which I haven’t posted or submitted anywhere. It’s now partly obsolete due to the new 2017 tax bill. But that’s actually a good thing, even from the comically self-centered standpoint of a writer with sunk costs. I felt a bit bored at times writing the piece, not always a recipe for one’s best work (although I think it has some good features), and I now have something fresh to put into it, i.e., responding to the new international rules in light of the framework that I use in the piece, which is based on my past international work.

So I have given myself homework for the holidays, in the form of printing out the international provisions in the final bill and conference report (I’m still old-fashioned enough to prefer paper for non-casual reading that is long-form), plus a few associated items that will help me think about them. And I plan to take more of a deep dive over the next couple of weeks than I have so far.

My initial sense of the international tax rules in the final bill is that they are less bad than the other features I have been discussing. That’s a pretty low bar, of course, when one has been thinking about the passthrough rules. But a couple of points in favor of the new international rules, compared to the bill’s worse elements are:

1) They started from what everyone agrees is really bad present law. (By contrast, the passthrough rules gratuitously screwed up something that was previously working fine, i.e., the absence of any such rules.) This inevitably affects a fair assessment of whether they have made things worse. Case in point, they’ve created incentives to move assets abroad, but under present law one may already have such incentives.

2) One thing that’s distressed me elsewhere in the bill is frequent lack of concern about tax avoidance, where that’s defined as taxpayers getting favorable results that don’t follow from a good faith policy aim. Case in point is not trying to limit exploitation of the 21% corporate rate by personal service corporations and the like. People incorporating so they can get the low rate for their labor income is NOT part of any reasonable rationale for lowering the corporate rate in response to international tax competition. Then, in the passthrough rules, while they make some effort to limit the ability of some service professionals to take advantage, the whole thing is so unprincipled to begin with that I’ve noted that I can’t see what the concept of undue tax avoidance even means there, unless one defines it as people and industries that the Republicans like versus those that they don’t like.

International is different. The extent to which they wanted to address tax avoidance seems clearly to have been greater than zero. Whether it’s adequate or well-executed is another question, but at least we are starting here from a higher baseline.

I also note that they seem to have at least gestured towards, and perhaps even implemented to a degree, a couple of ideas that I have been pushing in international tax policy debate. The first is steering away from what I call a 100% MRR (marginal reimbursement rate) for foreign taxes paid. Foreign tax credits that are allowable immediately are only one mechanism for having a 100% MRR in practice. Global “minimum tax” rules can also have this effect, as can anti-base erosion rules in some settings where they focus either directly or indirectly on shifting foreign income to tax havens.

A second idea that I’ve been pushing, and that I believe the bill reflects (but will have to study it more carefully) is that one’s base erosion rules shouldn’t over-rely on domestic residence.  Prior U.S. international tax law, even if it did too little overall about base erosion, did too much of what it did via the subpart F rules, which only apply to U.S. companies with foreign subsidiaries. The ability to have controlled foreign corporation (CFC) rules, like our subpart F, for domestic companies but not foreign companies means that one can do more to address (and fine-tune one’s addressing) base erosion by the domestic than the foreign. This creates a tradeoff, in that one may want to take advantage of the extra tools where one can, but there may otherwise be no reason to treat the residents worse than the nonresidents. Again, there appears to be some of this in the new rules, perhaps reflecting the political ease of going after foreign relative to domestic multinationals.

Some of the biggest defects in the new international rules may be multilateral or strategic. Obviously there is the treaty issue that Rebecca Kysar has been writing about, and that we discussed in both Games 1 and Games 2. Plus there are strategic issues: even insofar as doing X benefits the U.S. unilaterally – i.e., in the case where it doesn’t change what anyone else does – what if other strategic players actually do respond to us? The prospect of both imitation and retaliation can affect how we think about taking a given step, keeping in mind that the question here is how others change what they do by reason of what we did.

So there’s a lot for me to think about, but I do think I will end up sounding more measured, simply because a measured (even if in some respects critical) response seems more likely to be deserved.

Anyway, if I can bear to read all this stuff over the holidays – and, if not, I’ll do it in early January – then I will have some updates on what I think about it, eventually I’d presume in academic writing but initially here.

New doggerel, inspired by the tax act?

There’s a bit of old doggerel that I remember from Kurt Vonnegut’s Slaughterhouse Five, that goes something like this:

My name is Yon Yonson
I live in Wisconsin
I work in a lumberyard there
The people I meet when I walk down the street
Ask my name and I say:
My name is Yon Yonson
I live in Wisconsin
I work in a lumberyard there

In the aftermath of the 2017 tax act, I think we are ready for a new version. But I am still working on the fifth line.  Here’s what I have so far:

My name is Ron Johnson
I represent Wisconsin
My millions from passthroughs are there
The people I meet when I walk down the street
Ask which senator threatened to vote against the tax bill unless tax benefits for passthroughs were               expanded, and I say:
My name is Ron Johnson
I represent Wisconsin
My millions from passthroughs are there

The Act with no name

Here is the start of the 2017 tax bill, taken from the Conference Report:

Sec 11000. SHORT TITLE, ETC.
(a) SHORT TITLE.-This title may be cited as the “Tax Cuts and Jobs Act.”
(b) AMENDMENT OF 1986 CODE.-Except as otherwise expressly provided, whenever in this title an amendment or repeal is expressed in terms of … a section or other provision, the reference shall be considered to be made to a section or other provision of the Internal Revenue Code of 1986.
Why am I bothering you with this? Just bear with me here for a moment.
Here is the start of the 2017 tax bill, taken from the final enrolled act:
Sec 11000. SHORT TITLE, ETC.
(a) AMENDMENT OF 1986 CODE.-Except as otherwise expressly provided, whenever in this title an amendment or repeal is expressed in terms of … a section or other provision, the reference shall be considered to be made to a section or other provision of the Internal Revenue Code of 1986.
There is no section 11000(b) any more, and old (b) has of course become (a).
So what happened in the interim? They took out the bill’s title! It has no name now! (But there are still later statutory references to the Tax Cuts and Jobs Act, even though this has ceased to be a defined term.)
I specifically looked for this omission, when I got an electronic copy of the final bill, because I had heard that the Senate parliamentarian made them strike the name as a non-germane amendment.
This means absolutely nothing substantively, but perhaps I can be forgiven for finding it hilarious. They were in such a heedless rush that the bill ended up without a name! Of course, it doesn’t deserve a name.

Here’s a “dynamic” effect of the 2017 tax bill that we CAN expect to see

As I’ve noted in prior posts, one thing the tax bill does is strongly encourage non-employees to incorporate their businesses, including personal service businesses, and pay tax at only 21% federal. Even if they end up paying a second level of tax upon withdrawing their funds, there is almost no downside. And if they don’t need to withdraw the money directly, they may never end up paying that second level of tax. And Congress openly invited this result by providing that the tax rate for personal service corporations will be 21%, or the same as the general corporate rate.

Suppose a lot more people incorporate than the Joint Committee on Taxation anticipated when it scored the legislation. Then the overall revenue losses will be even bigger than the JCT predicted. But “corporate” revenue will be higher than forecast, due to the unanticipatedly high shifts.

One thing you can be certain of, if this happens: proponents of fake and overstated “dynamic” scoring will cherry-pick this number, and claim that it vindicates them. In short, an oversight that loses revenue will be treated by them as evidence that tax cuts actually do raise revenue. Of course, this requires staying tightly focused on corporate revenues, not overall revenues, but I am sure that this constraint will prove no difficulty.

Any good academic study of the revenue effects of the 2017 bill will, of course, take this issue into account. But competent and good-faith academic studies are not what I am talking about here.

UPDATE: BTW, this point was made to me by the WSJ’s Richard Rubin. Didn’t want to mention him by name without his approval.