Revisiting Federal Tax Treatment of States, Political Subdivisions, and Their Affiliates

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Ellen P. Aprill


Several provisions of the 2017 tax legislation, known as the Tax Cuts and Jobs Act (TCJA), 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. States have sued and attempted workarounds. Another pro­vision, which imposes an excise tax of 21% on “excessive compensa­tion” paid by certain entities not subject to income tax, inadvertently failed to subject to tax entities that are integral parts of states or polit­ical subdivisions or are themselves political subdivisions. Calls for a technical correction have so far gone unheeded.

More than 20 years ago, I wrote two articles about federal tax­ation of state governments, political subdivisions, and their affiliates. The Teacher’s Manual to a leading casebook on nonprofit organiza­tions describes these two articles as “as much as anyone knows about this confusing patchwork and its ramifications.” The passage of time, changes in my own thinking, and new developments call for my return­ing to this topic. I do so here. Moreover, far more than in my earlier work, I examine the applicable rules regarding charitable contribution deductions to these entities as well as discuss the special rules applicable to governmental charities and the category of charities that lessen the burdens of government.

In light of the 2017 tax legislation, I not only renew recommen­dations made long ago, but also extend them to the criteria for exempt­ing entities that lessen the burdens of government, a category that has received little scholarly attention. I also call for establishing a system by which states, political subdivisions, and their affiliates could receive determination letters, like those issued to section 501(c) organizations and thus familiar to potential donors. Such an approach would avoid the distortion of the rules applicable to section 501(c)(3) that arises from the current special treatment of governmental charities. Treating gov­ernmental entities as a distinct category under the Internal Revenue Code, with their own criteria and their own determination letter, would also acknowledge and honor their role in our federalist system.

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