INTRODUCTION 74 I. STATES AND POLITICAL SUBDIVISIONS, INTEGRAL PART, AND SECTION 170(C)(1) 81 A. Qualification as a Political Subdivision 81 B. Integral Part of State or Political Subdivision 88 C. Charitable Contribution Deduction 94 II. SECTION 115 EXCLUSION ENTITIES AND SECTION 170 (C) (1) 95 A. Qualification as a Section 115 Exclusion Entity 95 B. Charitable Contribution Deduction 105 III. GOVERNMENTAL CHARITIES 108 A. Qualification 108 B. The Special Status of Governmental Charities 114 C. Charities That Lessen the Burden of Government 118 IV. RECOMMENDATIONS AND CONCLUSION 125 APPENDIX 128 INTRODUCTION
Several provisions of the 2017 tax legislation, known as the Tax Cuts and Jobs Act (TCJA), (1) focused attention on federal taxation of states, their political subdivisions, and their affiliates. Most prominently, the TCJA limited the federal income tax deduction for state and local taxes to $10,000. (2) The Attorneys General of New York, Connecticut, Maryland, and New Jersey--high-tax, blue states--promptly filed suit arguing that the new limit violated the Constitution by exceeding the federal government's power to impose an income tax. (3)
A number of states also sought "workarounds" to the federal limit. In one leading workaround, states granted income tax credits for contributions eligible for deduction under section 170(c), including entities affiliated with states or political subdivisions. (4) In response to these state reactions, Treasury and the Internal Revenue Service (IRS) issued proposed regulations in August 2018. (5) They reduced any charitable contribution by the amount of any state tax credit allowed for such contribution deduction in excess of 15% of the taxpayer's contribution. The proposed regulations applied the reduction to all entities for which a deduction is permitted under section 170(c). To the dismay of some and the joy of others, contributions to longstanding credit programs benefitting private schools, not just newly created and government-sponsored entities, would require reduction. (6)
The Treasury Department and the IRS received more than 7,700 comments on the proposed regulations. (7) The final regulations followed the proposed regulations, with some small clarifications and technical changes. (8) For example, under the final regulations, only if the taxpayer receives state and local tax credits that do not exceed 15% of the taxpayer's contribution will the taxpayer be able to avoid the reduction. (9) They also announced a safe harbor under which deductions disallowed because of receipt of state tax credits may be treated as a payment of state or local taxes for purposes of section 164. (10) Plans to challenge the regulations followed immediately. (11)
This set of moves and countermoves by the states and the federal government demonstrates what Professor Jessica Bulman-Pozen has dubbed "partisan federalism." (12) As she explains, under partisan federalism, "States controlled by one party challenge the federal government when it is controlled by the other party." (13) She asserts that "[p]artisanship is crucial to understanding contemporary American federalism." (14)
Partisan federalism represents but one strand in the bundle that we call federalism. As Herbert Wechsler observed in a now classic article, the Founders "preserved the states as separate sources of authority and organs of administration." (15) That is, our very constitutional structure calls for the federal government to afford respect to states and their political subdivisions. Thus, for example, another provision of the TCJA, new section 4968, (16) imposes an excise tax of 1.4% on the endowment of certain universities, but carefully excludes from its reach any public colleges and universities. (17)
Wechsler's model of federalism has come to be known as "process federalism." It asserts that states must rely on the political system, in particular the structure of Congress, rather than the federal courts to protect their interests. Process federalism reached its zenith in Garcia v. San Antonio Metropolitan Transit Authority. (18) There, the Court held that Congress has power under the Commerce Clause to apply the Fair Labor Standards Act to employees of state and local governments. The Court denied states "judicially created limitations on federal power" for protection of state sovereign interests. (19) Writing for the five-person majority, Justice Blackmun declared:
In short, the Framers chose to rely on a federal system in which special restraints on federal power over the States inhered principally in the workings of the National Government itself, rather than in discrete limitations on the objects of federal authority. State sovereign interests, then, are more properly protected by procedural safeguards inherent in the structure of the federal system than by judicially created limitations on federal power. (20) States, however, can take advantage of political safeguards only if they have notice of the need to deploy their political power. Thus, in Gregory v. Ashcroft, the Court declared that congressional intent to "intrude on state governmental functions," at least those involving decisions "of the most fundamental sort for a sovereign entity," must be "plain to anyone reading the Act." (21) The opinion cautioned that "[t]o give the state-displacing weight of federal law to mere congressional ambiguity would evade the very procedure for lawmaking on which Garcia relied to protect states' interests." (22)
TCJA also demonstrates this version of federalism. New section 4960 imposes an excise tax of 21% on "excessive compensation" paid by certain entities not subject to income tax. As I and others have explained, (23) the provision as adopted fails to carry out fully Congress's intention. The language of section 4960 does not tax entities that are integral parts of states or political subdivisions or are themselves political subdivisions. It fails the requirement of Gregory that Congress include--unambiguously--states and political subdivisions if they are among applicable organizations subject to the excise tax. (24)
The IRS, Treasury, and the Joint Committee on Taxation agree. The Joint Committee's General Explanation of Public Law 115-97 states that organizations taxed under section 4960 "are intended to include State colleges and universities," but that "[a] technical correction may be necessary to reflect this intent." (25) Notice 2019-09, Interim Guidance under Section 4960, issued by the Treasury Department and the IRS, explains that organizations subject to the excise tax do not include "a governmental [unit] (including a state college or university)" unless the government unit falls within one of the categories specified in section 4960. (26)
Thus, different provisions of the TCJA offer different varieties of federalism. (27) All of these provisions, however, indicate the need for care when the federal government taxes--or determines not to tax--states and their political subdivisions. More than 20 years ago, I wrote two articles about federal taxation of state governments, political subdivisions, and their affiliates. (28) The passage of time, changes in my own thinking (ah, age and perhaps maturity), and new developments call for my returning to this topic. Moreover, far more than in my earlier work, I will examine the applicable rules regarding the deduction for contributions to these entities. Understanding the ongoing and contentious state and local tax (SALT) dispute requires knowledge of these categories and rules--in particular, the long history of governmental charities and what it means that charitable contributions to governments are deductible only if the gift or contribution "is made for exclusively public purposes." (29)
Currently, as "a special service to government entities," the IRS will provide '"a governmental information letter' free of charge." (30) This letter describes the basic categories of states and their affiliates. The letter, intended to substitute for a private letter ruling in order to substantiate the entity's tax status and its ability to receive deductible contributions, (31) describes three categories: (1) governmental units, such as states and their political subdivisions; (2) entities that are not governmental units but have their income excluded from gross income under section 115(1) on the basis that their income derives from a public utility or an "essential governmental function" and accrues to a state or political subdivision (hereinafter a "section 115 exclusion entity"); and (3) organizations affiliated with a state, county, or municipal government that qualify for exemption under section 501(c)(3). (32)
As in my earlier work, I will discuss the requirements not only for these three basic categories, but also for treating an endeavor as an integral part of a state or political subdivision. In this Article, I will consider applicable charitable contribution deduction rules. The tests for an entity to be an instrumentality of a state or political subdivision, a category that does not itself establish exemption, figure importantly in determining the deductibility of donations to section 115 exclusion entities. The Article will also examine another category closely related to state governments and their political subdivisions: entities exempt under section 501(c)(3) on the basis that they lessen the burdens of government.
In my first article on this topic, I urged Congress to clarify these confusing and overlapping categories. In the second, I urged Treasury and the IRS to issue regulations that do so. Both sets of pleas fell on deaf ears. In light of the 2017 tax legislation, perhaps the recommendation from long ago that the IRS promulgate regulations in this area will find acceptance. In this Article, I will also make recommendations regarding the criteria for tax-exempt entities that lessen the burdens
of government. Further, I suggest...