Dept. of Bad Ideas: Why Charitable Schemes to Offset the New Tax Law Won't Work

photo:  Ryan R Fox/shutterstock

New York and California, two of the highest state tax municipalities are complaining that the new federal income tax regulations which limit the federal deduction for state and local taxes to $10,000 results in a tax increase for their citizens. They are trying to concoct workarounds. Citizens should beware of at least one of the ideas gaining traction in the press and state legislatures.

The idea most often discussed is for a state to create a charitable organization that will allow residents to make a deductible charitable contribution, and at the same time lower their state income or property taxes below the $10,000 deduction ceiling. A resident would be encouraged to donate to the (say) the New York (whatever name they call it) and receive a tax credit for the full amount of their gift. The tax credit would be applied against the NY state income tax or local property tax the resident is billed. California, moving quickly, is already calling its charity the “California Excellence Fund.”

This idea if flawed from an Internal Revenue Code standpoint and will not work.

The Internal Revenue Code already has a well-established regulation that disallows a charitable contribution deduction when the donor makes what is called a “quid-pro-quo” payment to a charity. For example, if your child’s private school tuition is $10,000 per year, you cannot make a $10,000 charitable contribution to the school in exchange for a scholarship of other tuition remission for your child. The value of what the donor received in return for their contribution was equal to the tuition amount, thereby eliminating the deductibility of the amount paid.

Even if the donor made a $12,000 contribution to the school in exchange for $10,000 of tuition remission, the donor would only be able to deduct $2,000 as a charitable contribution. This rule applies to every payment to a charity. Did you pay $500 to play golf in a charity golf outing where the value of the lunch, greens fees, and dinner you receive are $300? In such a situation, the charity is obligated by IRS regulation, to provide you with a receipt indicating that you received $300 of value in exchange for your $500 payment and you are only able to deduct $200 on your federal income tax return as a charitable contribution. This is the classic “quid-pro-quo” payment to a charity.

The charity is obligated by law to provide you with such a receipt or face financial penalties. The taxpayer/donor is obligated to have a written receipt indicating the amount of any value received in exchange for payment for all payments to a charity in excess of $250. If the taxpayer has no written receipt for payments in excess of $250, the IRS may disallow a deduction for the entire amount paid.

These regulations have been in existence for over 30 years. They are well established and are not likely to change.

A state that claims that it will provide you with a tax credit to apply against your state income tax or local property tax, in exchange for a donation to their charity, has yet to understand these regulations. It is not possible for the state to provide the taxpayer with a receipt for say $3,000 paid to the “California Excellence Fund” and also confirm in writing that the taxpayer did not receive anything of value in exchange for the contribution. If the taxpayer does not have a receipt documenting that they received nothing of value in exchange for their contribution, they will be unable to deduct the payment on their federal income tax return.

Why is the IRS remaining silent as these elaborate plans are discussed by state legislative bodies? Simply stated, the IRS is responsible for the enforcement of tax regulations and it has no responsibility to comment on tax planning schemes. The IRS will make its position known the first time it receives a tax return that has deducted one of these inappropriate “charitable contribution” payments.

This is more than just a New York and California issue. Even tiny Rhode Island is exploring the charitable contribution scheme. It's remarkable how little awareness there is that such workarounds of the new 2018 tax laws will not work.