As states seek charitable ways to skirt federal tax law, philanthropy must watch out

California, that cradle of legislative creativity, has become the first state to take concrete steps to help people avoid the new limit on federal deductions for state and local taxes. The state’s Senate has overwhelmingly passed a bill to let Californians pay 85 percent of their state taxes into a state-run charity, on the theory that if the payments are charitable contributions, they’ll be more deductible than if they were tax payments.

The Treasury Department tells the Wall Street Journal that it’s “skeptical” of the idea. One contributing fact may be that if taxpayers can avoid the new deduction limit, the government stands to lose billions in revenues over the next 10 years.

But something bigger may be at work: After years of contending that philanthropic donations should be treated more like government money, the government is now reasserting that the two categories are different.

Philanthropy should be grateful.

Under the old rules, federal taxpayers could deduct unlimited amounts of property taxes and state income or sales taxes. The deduction wasn’t a favorite of tax experts, who say that federal deductibility, by dulling the pain of state taxes, lets states impose higher taxes that support bigger state budgets. The deduction is a subsidy to high-tax states.

But beginning in 2018, taxpayers can deduct only $10,000 of these tax payments. If high-tax states don’t like the increased tax burden on their citizens, they’re told, they can simply stop levying so much in taxes of their own.

High-tax states don’t see this advice as helpful.

On the individual level, one response has been sometimes-frantic workaround attempts. After the law was signed in December, a number of taxpayers rushed to prepay their 2018 property taxes in 2017 so they could deduct them in full on their 2017 federal tax returns, before the new law applied. Most of them found that, for one technical reason or another, they couldn’t do it.

On the official level, there are accusations of discrimination, vengefulness—how suspicious that the new limit hits mainly liberal states!—and other unfairness. New York’s Gov. Andrew Cuomo called the new law an act of “economic civil war” and said the state would sue.

Meanwhile, in contrast to the upheaval in state and local deductions, the federal rules on charitable deductions have become slightly more generous: If taxpayers itemize, their charitable contributions up to 60 percent of their adjusted gross income—instead of 50 percent under prior rules—are generally deductible.

The California plan trades off the increased charitable deduction for the reduced state and local deduction, proposing what might be called a “Dilot,” a donation in lieu of taxes. Under the plan, the state would set up a charitable fund. Although a California taxpayer who directly paid a state tax bill of $20,000 could deduct only $10,000 for federal tax purposes, the same taxpayer could donate 85 percent of the bill, or $17,500, to the fund; the amount would reduce state tax liability; and the taxpayer could deduct the entire $17,500 from federal taxes.

American ingenuity at work.

The California plan has precedents. Generally, donations to government are deductible if they’re made for a “public purpose.” States have allowed credits against state taxes for charitable donations to organizations such as clinics, universities, homeless shelters, and scholarship funds, or even directly to state and local governments for such purposes as conservation easements or maintaining public parks. These payments have generally been treated as federally deductible.

For the most part, the IRS hasn’t directly examined the practice. There wasn’t much need since, except for taxpayers subject to the alternative minimum tax (which doesn’t allow for this deduction), the state and local deduction was more generous than the charitable deduction. One 2010 IRS memo, which is not official guidance, set out IRS thinking on the issue: It allowed federal charitable deductions after taxpayers donated to three state agencies and a nonprofit in return for state tax credits. But the memo was written before today’s wide gap between charitable deductions and state and local tax deductions — and before the huge benefits conferred on taxpayers by plans like California’s. It’s a new ballgame, folks.

Thomas West, the Treasury Department’s tax legislative counsel, the one who expressed the department’s skepticism about the California plan, noted that the bigger the benefit received by the taxpayer in exchange for a “charitable” contribution, the closer the transaction comes to what West called “something else” — that is, not a deductible contribution at all.

Moreover, the taxpayers in the IRS memo ultimately got to choose the recipients of their contributions and didn’t receive an equivalent benefit in return for them. But the California plan would give state tax credits only for donations to the state’s fund, and the fund’s money will be spent for purposes ultimately determined by the State of California. That sounds an awful lot like — well, taxes.

In fact, California’s plan sounds like such a nonstarter that it raises a question: How did it come to seem so plausible that a charitable contribution could be treated just like taxes?

Part of the reason is history. Ever since the beginning of the charitable deduction, government spending for public purposes and philanthropic spending for public purposes have been conflated.

Indeed, the deduction is rooted in the assumption that the public work done by charities is similar in nature to the public work performed by government — so similar, in fact, that charities should be spared ordinary taxpaying obligations.

The same idea underlies the fact that nonprofits can qualify for federal tax exemptions partly by “lessening the burdens of government,” which is the basis for nonprofits’ objections to the growing number of municipalities trying to force them to make “payments in lieu of taxes,” often referred to by their acronym, Pilots.

In recent years, as public schools, libraries, parks, and other government agencies have set up private nonprofit arms to support their work, the lines between philanthropic contributions and “public money” have blurred even more.

Today there’s a fund in Kalamazoo, Mich., that’s trying to raise a half-billion dollars to mitigate the city’s budget problems. These practices reinforce the idea that because foundations and other donors get valuable benefits from the public treasury in the form of tax exemptions and deductions, private contributions should be subject to more of the same publicly imposed constraints that apply to actual government money.

Now, the Treasury Department says, when you get down to basics—that is, federal deductibility—giving to government and giving to philanthropy are two different things. Private control of money, even money dedicated to public purposes, is not the same as public control of money through the mechanisms of politics and government. This distinction happens to be one on which American philanthropy depends. It’s good to have someone remind us.

Leslie Lenkowsky is an Indiana University expert on philanthropy and public affairs. He and Suzanne Garment, a visiting scholar at Indiana University, write frequently on philanthropy and public policy.