States Explore Strategies to Avoid SALT Deduction Limitation
Even before the final passage of the Tax Cuts and Jobs Act, politicians in high-tax states started looking for ways to eliminate, or at least reduce, the impact of the new limitation on the itemized deduction for state and local taxes (SALT). Will they be successful?
Prior to the Tax Cuts and Jobs Act (Act), personal taxpayers who itemized their deductions could generally deduct SALT without limitations. Beginning in 2018, the Act limits an individual’s deduction for aggregate state and local taxes to $10,000 per calendar year ($5,000 in the case of a married individual filing a separate return).
Offsetting this new limitation are:
- Increases in the standard deduction (meaning fewer taxpayers will itemize)
- Changes in how personal alternative minimum tax is calculated (fewer taxpayers paying AMT)
- Lowering of federal tax rates
However, some high-income taxpayers in high-tax states could be adversely effected. New York State has the highest state tax burden in the country and Gov. Andrew Cuomo tweeted in October 2017 that “New York will be destroyed…”.
Work Around #1-Paying Taxes via Charitable Deductions
Several states are working on similar proposals where taxpayers will make “donations” to “charitable organizations” and receive up to a dollar-for-dollar credit against their state and/or local taxes. Charitable donations are still deductible without limitation. The “charitable organizations” that receive the “donation” are controlled by the subject governmental entity and are generally obligated to remit the “donations” to that governmental entity.
While state and local government and related entities are eligible to receive deductible contributions, the contributions are deductible only if it is to be used solely for public purposes. It is difficult to argue that the above arrangement is solely for public benefit, as governmental entity gains no additional revenue or resources, only the “donor” gains-a tax deduction.
Further, the Internal Revenue Code provides that if a liability is assumed by the recipient as a result of a contribution, the amount deductible is reduced by the amount of that liability. The tax credit granted under this scheme would appear to be such a disqualifying liability.
Lastly, if a donor expects to receive a substantial benefit as a result of the donation, the donation is not deductible. The dollar-for-dollar tax liability reduction would surely constitute such a benefit. (Some proposals under this workaround scenario provide for an 85% credit, but this minor difference would not change the arguments against it).
The IRS is aware of these proposals and, in Notice 2018-54, reminded taxpayers that federal law controls the proper characterization of payments for federal income tax purposes. Further, the IRS stated they would be developing regulations on this matter and that “the proposed regulations will make clear that the requirements of the Internal Revenue Code, informed by substance-over-form principles, govern federal income tax treatments of such transfers.”
Workaround #2-Converting State Income Tax to a Payroll Tax
The state of New York is pioneering the second alternative workaround. In it, a New York employer could opt into an Employer Compensation Expense Program paying a new payroll tax of 5% (when fully phased in) on employee compensation exceeding $40,000. The employer would bear the expense of this tax and would be able to deduct it without limit. The law prohibits the employer from deducting the amount of the new tax from the employee’s wages. The employee would be entitled to take a credit for the amount of the tax paid on his salary, reducing his New York state tax liability.
While the tax paid by the employer would appear to be deductible, the credit the employee receives arguably demonstrates that the employer is actually paying state income tax on behalf of the employee. Accordingly, the IRS could argue that the employee’s taxable wages should be increased by the amount of the subject payroll tax paid.
Another issue with this scheme is that while the law prohibits the employer from deducting the payroll tax from employee wages, the employer could reduce the employee’s wages to arrive at the same net compensation. It is hard to envision an employer volunteering to bear the economic expense of paying employee state income taxes.
As CPA’s we are trained to strive to minimize taxes paid by our client while still complying with the law and regulations. As things stand today, I would not advise a client to pursue these workarounds.