Why California’s Attempt to Make State Taxes a Charitable Deduction is Doomed

When your budget is out of balance there are two ways of getting it in balance: cutting spending or increasing revenue. For California’s Democratic politicians, the only way they want to balance the budget is to increase the revenue. The new tax law puts a crimp on California (and other “Blue” states) by limiting the deduction of state income taxes and property taxes to $10,000. Kevin de Leon, California Senate President Pro Tempore, came up with the idea of having Californians being able to make a charitable donation to the “California Excellence Fund” instead of paying state taxes; that would allow the deduction to be taken on the taxpayer’s tax return and getting around the $10,000 limitation. Senator de Leon’s measure, though, will not pass IRS scrutiny for four reasons.

First, a charitable donation must be voluntary, not mandatory. That the contribution is used for the “California Excellence Fund”–an that fund is used for the general budget–makes this the equivalent of state tax paid. That makes this a mandatory payment, not a voluntary one, and it is, thus, not a charitable donation.

Second, Senator de Leon cites previous state contributions such as in Arizona, where taxpayers made contributions to parochial schools via a state fund as a charitable contribution. There’s a big difference between that and this California proposal: Mr. de Leon’s proposal would be for the general fund, with the money used in normal state revenues. That’s not going to work.

Third, taxpayers cannot obtain any benefit from the contribution. For example, if you donate $100 to a charity and receive (say) a blanket worth $10, your deductible charitable contribution is $90. Since the whole idea of this is to give taxpayers a charitable contribution in return for taxes paid, the amount that is deductible would be a benefit received and not deductible.

Fourth, there’s a doctrine in tax called “Substance Over Form.” This doctrine basically says that the economic substance of a transaction determines how it is treated for tax purposes, even if its labeled as something else. If you label something as a charitable contribution but it’s really a tax payment, under “Substance Over Form” it will be treated as a tax payment.

Thus, I believe that the efforts by Democrats such as Kevin de Leon are doomed to failure. I expect the IRS to rule–if this measure becomes law–that contributions to the California Excellence Fund are only charitable contributions if they exceed the required amounts to be paid for state income tax.

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