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## Why the Idea of State Tax Credits and Donations Replacing Deductibility Won’t Work and How to Fix That

The new tax bill limits the deduction for state and local taxes to \$10,000.  This comes after the alternative minimum tax (AMT) already limits them if someone has enough capital gains and deductions to qualify for it, which a lot of people do.  Can states do anything to help their taxpayers?

Solution 1. Convert the state income tax to a payroll tax on businesses. Instead of the taxpayer paying 5% on income and the business 0% on it, have the taxpayer pay 0% and the business pay 5% of salaries. The business would be able to deduct it.

Problem: This only helps with taxes on employee labor income, not with property taxes and capital taxes.

Solution 2. Create a 100% state tax credit for donations to the State Treasury. Then someone can cover his \$20,000 state tax bill by making a \$20,000 donation to the State Treasury, and he will be able to deduct the donation like he can any charitable donation.

Problem: This doesn’t count as a charitable donation, because the donor receives back 100% equal value from the recipient.

I’ll expand on this problem.

Hypothetical 1: John Doe donates \$500 to the Indiana state treasury under the current state tax regime. He can deduct the full \$500 from his income for federal tax, as a charitable deduction. His state tax is unaffected. In fact, in Indiana, he can’t deduct the \$500 from his income for state tax purposes; he still has to pay income tax on it.

Hypothetical 2: John Doe donates \$500 to the Salvation Army and in gratitude they give him a \$50 jacket. He can deduct the \$450 from his income for federal tax, as a charitable deduction, because the donation was partly payment for goods and services. Hypothetical 2 is the problem for solution 2.

Hypothetical 3: John Doe donates \$500 to the Sagamore Fund, a nonprofit authorized by the state of Indiana to give scholarships to poor kids at private schools. Indiana allows a 50% tax credit for such donations. He can deduct the full \$500 from his income for federal tax, and can subtract \$250 from his Indiana income tax.

Hypothetical 3 is the reason people are hopeful about solution 2. But note the difference from Hypothetical 2: in hypothetical 3, the donor receives nothing of value from the recipient. Rather, he receives something of value from a third party, and that is OK. It is like Hypothetical 4:

Hypothetical 4: John Doe donates \$500 to  Lighthouse Christian School to  give scholarships to poor kids. Richard Roe has agreed to forgive   debt owed to him by anyone who donates to the School, dollar for dollar. John Doe can deduct the full \$500 from his income for federal tax,  though he has an extra \$500 in forgiveness-of-debt income (or perhaps it’s earned income; I don’t know and it doesn’t matter).  He does have to pay state income tax on this new \$500 in income. Note that Richard Roe cannot deduct anything; he has not made a charitable contribution; he has either forgiven a personal debt or paid someone to do something for him.

How about if the State doesn’t insist on the money going to the State Treasury? That would probably work. It would be like this:

Hypothetical 5: John Doe donates \$100 to Indiana University. Indiana allows a 100% tax credit for such donations, up to a limit of \$100 (it really does, to the best of my recollection). Doe can deduct the full \$100 from his income for federal tax and pay \$100 less in state income tax.

Hypothetical 5 is not formal IRS policy, I think, though Daniel Hemel referred me to a private letter ruling or something like that. But it makes sense. Indiana University is a distinct legal person, different from the State of Indiana.  The legislature and the governor do not directly control it, though they have great influence through appointments to its board and through appropriations which pay for a little of its budget (surprisingly little!).  Thus, what New York State could do is create a 100% credit on its state and local taxes (including property taxes) for donations to Cornell University.  It would also need to create a new nonprofit corporation to run Medicaid in New York State and make it eligible for credit donations.

January 10: I just posted Getting Around the State and Local Tax Deduction Limit (January 9, 2018). Available at SSRN: https://ssrn.com/abstract=3099296.

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