The new limit on individuals’ deductions for state and local taxes (SALT) ranks among the most significant changes to individual income taxes under the Tax Cuts and Jobs Act (TCJA), particularly for taxpayers in high-tax states. In response, some of these states have enacted or are considering statutory workarounds, but these tactics seem likely to fail.
Although initially targeted for elimination, a reduced SALT deduction survived and was included in the TCJA legislation signed by President Donald Trump. Beginning in 2018 and continuing through 2025, taxpayers can claim a deduction of no more than $10,000 for the aggregate of state and local property taxes and income or sales taxes. Moreover, the deduction remains available only to taxpayers who itemize their deductions. With the standard deduction increased to $24,000 for married couples and $12,000 for single filers, far fewer taxpayers are expected to itemize.
Proposed workarounds
A number of states – including New York, New Jersey, Connecticut, California, and Oregon – are pursuing legislative relief for their residents who will be adversely affected by the new limit. Generally, these plans would allow taxpayers to make payments to funds controlled by state or local governments, or other specified transferees, in exchange for a tax credit against state and local taxes owed. The intent is to allow taxpayers to characterize the transfers as fully deductible charitable contributions for federal income tax purposes while using them to satisfy state or local tax liabilities.
For example, New Jersey has passed a law giving taxpayers the option to make charitable contributions to their municipality, county, or school district and receive property tax credits in return. Taxpayers can receive a tax credit of as much as 90 percent for their contributions.
In addition to a charitable contribution credit similar to New Jersey’s, New York has adopted an Employer Compensation Expense Tax, effective Jan. 1, 2019. It gives employers in the state the option to pay a new payroll tax imposed on their annual payroll expense for covered employees who earn in excess of $40,000. The tax rate begins at 1.5 percent for 2019 and rises to 5 percent when fully phased in for 2021. Covered employees receive a credit to offset their New York personal income tax in an amount equal to the payroll tax. Employers that elect the tax incur a payroll tax expense that is designed to be deductible for federal income tax purposes, while covered employees have their state income tax liability reduced in exchange for higher payroll taxes.
Implementation of this approach could prove challenging. The amount attributable to the entity-level tax paid on behalf of employees could be deemed compensation for federal income tax and employment tax purposes. Moreover, the payroll tax appears to inadvertently penalize out-of-state employees and resident employees with income subject to taxation in other states. Out-of-state employees will not be able to use a tax credit in their home states for the payroll tax, and resident employees will be unable to use their out-of-state tax obligations to offset New York tax.
Connecticut has taken yet another tack, creating an entity-level income tax for pass-through entities (including partnerships, limited liability companies, S corporations, and sole proprietorships). Because the entity – rather than individual partners, shareholders, or members – is paying the tax, it is not subject to the deduction limit for federal purposes. The business owners also receive a corresponding tax credit against their state income taxes. For the most part, benefit will be limited to state residents who are owners of pass-through entities that primarily operate in Connecticut.
The IRS stance
The ultimate success of these strategies remains to be seen. The IRS conceivably could treat payments attributable to employees under New York’s payroll plan as deemed compensation. This is because employees of businesses that did not elect to participate in the optional program still would be subject to New York individual income tax. Thus, participating employers in effect would be paying individual employees’ state tax obligations that otherwise would be owed.
In May 2018, the IRS addressed the wave of state workarounds in Notice 2018-54, which implies that the agency does not consider some workarounds valid. The notice states that the IRS will issue proposed regulations on the federal income tax treatment of certain taxpayer payments for which they receive a credit against their state and local taxes. It also warns taxpayers that federal law controls the proper characterization of payments for federal income tax purposes.
The notice explains that the IRS will apply substance-over-form principles to its analysis of deductions, meaning it will consider the economic realities of the transactions rather than their labels. In other words, the fact that a deduction is characterized as representing a charitable donation does not mean that the IRS will treat it as such if, in substance, it actually is a state and local tax payment.
In July 2018, the states of New York, New Jersey, Maryland, and Connecticut filed a lawsuit against the federal government seeking to invalidate the TCJA’s limit. Their complaint alleges that the limit, “as many members of Congress transparently admitted, … deliberately seeks to compel certain States to reduce their public spending.” The states urge the court to invalidate “this unconstitutional assault on the States’ sovereign choices.”
Despite the pending litigation, individual taxpayers who proceed under these new laws do so at their own peril. If the IRS denies their claimed charitable deductions – and judicial authorities uphold assessments – they could end up on the hook for penalties and interest, as well as additional federal tax.
Proceed with caution
The state workarounds are replete with potential traps, so taxpayers should proceed with utmost caution. Rather than chafing at the limit, taxpayers might be better off focusing on the positive. Because the TCJA significantly increases the exemption amounts and phase-out thresholds for the alternative minimum tax, many upper-income taxpayers who previously were unable to receive any tax benefit from SALT payments now may be able to deduct up to $10,000 of those taxes.
Although initially targeted for elimination, a reduced SALT deduction survived and was included in the TCJA legislation signed by President Donald Trump. Beginning in 2018 and continuing through 2025, taxpayers can claim a deduction of no more than $10,000 for the aggregate of state and local property taxes and income or sales taxes. Moreover, the deduction remains available only to taxpayers who itemize their deductions. With the standard deduction increased to $24,000 for married couples and $12,000 for single filers, far fewer taxpayers are expected to itemize.
Proposed workarounds
A number of states – including New York, New Jersey, Connecticut, California, and Oregon – are pursuing legislative relief for their residents who will be adversely affected by the new limit. Generally, these plans would allow taxpayers to make payments to funds controlled by state or local governments, or other specified transferees, in exchange for a tax credit against state and local taxes owed. The intent is to allow taxpayers to characterize the transfers as fully deductible charitable contributions for federal income tax purposes while using them to satisfy state or local tax liabilities.
For example, New Jersey has passed a law giving taxpayers the option to make charitable contributions to their municipality, county, or school district and receive property tax credits in return. Taxpayers can receive a tax credit of as much as 90 percent for their contributions.
In addition to a charitable contribution credit similar to New Jersey’s, New York has adopted an Employer Compensation Expense Tax, effective Jan. 1, 2019. It gives employers in the state the option to pay a new payroll tax imposed on their annual payroll expense for covered employees who earn in excess of $40,000. The tax rate begins at 1.5 percent for 2019 and rises to 5 percent when fully phased in for 2021. Covered employees receive a credit to offset their New York personal income tax in an amount equal to the payroll tax. Employers that elect the tax incur a payroll tax expense that is designed to be deductible for federal income tax purposes, while covered employees have their state income tax liability reduced in exchange for higher payroll taxes.
Implementation of this approach could prove challenging. The amount attributable to the entity-level tax paid on behalf of employees could be deemed compensation for federal income tax and employment tax purposes. Moreover, the payroll tax appears to inadvertently penalize out-of-state employees and resident employees with income subject to taxation in other states. Out-of-state employees will not be able to use a tax credit in their home states for the payroll tax, and resident employees will be unable to use their out-of-state tax obligations to offset New York tax.
Connecticut has taken yet another tack, creating an entity-level income tax for pass-through entities (including partnerships, limited liability companies, S corporations, and sole proprietorships). Because the entity – rather than individual partners, shareholders, or members – is paying the tax, it is not subject to the deduction limit for federal purposes. The business owners also receive a corresponding tax credit against their state income taxes. For the most part, benefit will be limited to state residents who are owners of pass-through entities that primarily operate in Connecticut.
The IRS stance
The ultimate success of these strategies remains to be seen. The IRS conceivably could treat payments attributable to employees under New York’s payroll plan as deemed compensation. This is because employees of businesses that did not elect to participate in the optional program still would be subject to New York individual income tax. Thus, participating employers in effect would be paying individual employees’ state tax obligations that otherwise would be owed.
In May 2018, the IRS addressed the wave of state workarounds in Notice 2018-54, which implies that the agency does not consider some workarounds valid. The notice states that the IRS will issue proposed regulations on the federal income tax treatment of certain taxpayer payments for which they receive a credit against their state and local taxes. It also warns taxpayers that federal law controls the proper characterization of payments for federal income tax purposes.
The notice explains that the IRS will apply substance-over-form principles to its analysis of deductions, meaning it will consider the economic realities of the transactions rather than their labels. In other words, the fact that a deduction is characterized as representing a charitable donation does not mean that the IRS will treat it as such if, in substance, it actually is a state and local tax payment.
In July 2018, the states of New York, New Jersey, Maryland, and Connecticut filed a lawsuit against the federal government seeking to invalidate the TCJA’s limit. Their complaint alleges that the limit, “as many members of Congress transparently admitted, … deliberately seeks to compel certain States to reduce their public spending.” The states urge the court to invalidate “this unconstitutional assault on the States’ sovereign choices.”
Despite the pending litigation, individual taxpayers who proceed under these new laws do so at their own peril. If the IRS denies their claimed charitable deductions – and judicial authorities uphold assessments – they could end up on the hook for penalties and interest, as well as additional federal tax.
Proceed with caution
The state workarounds are replete with potential traps, so taxpayers should proceed with utmost caution. Rather than chafing at the limit, taxpayers might be better off focusing on the positive. Because the TCJA significantly increases the exemption amounts and phase-out thresholds for the alternative minimum tax, many upper-income taxpayers who previously were unable to receive any tax benefit from SALT payments now may be able to deduct up to $10,000 of those taxes.
