- The Tax Cuts and Jobs Act affects individuals in high-tax states who itemize deductions, limiting the SALT deduction.
- Some states pass legislation on charitable deduction workarounds.
- Four states jointly file suit against federal government on SALT limitation.
The Tax Cuts and Jobs Act (TCJA) enacted in December 2017 made significant changes to rules of how individuals calculate their federal income tax liability. One of these changes particularly crucial to high-tax states was the limit to the state and local income tax (SALT) deduction. The new law capped SALT deductions at $10,000 ($5,000 married filing separately). The cap takes into consideration income (or sales), as well as property taxes in aggregate.
The new cap affected individuals who itemize their deductions (instead of using the standard deduction) and whose SALT deduction would exceed the $10,000 cap. With the standard deduction almost doubling, fewer individuals are expected to itemize because their itemized deductions on Schedule A would not exceed the new standard deduction of $12,000 for individuals and $24,000 for married filing jointly. However, this limitation would result in an increased federal tax bill for individuals whose itemized deductions exceeded the standard deduction without factoring in the SALT cap.
High-tax states whose citizens were disproportionately impacted by this cap began responding by developing tax policies that would reconstitute their income tax in a way that it still might be deductible.
Proposed guidance summary
In August, the IRS issued guidance that negated some of these state proposals as viable workarounds, following up on notice 18-54 issued in May that warned how a shifting of funds – essentially, transferring payments to other state funds meant to satisfy state tax obligations – might result in a compliance issue. The proposed guidance detailed specifics of how state laws and legislative proposals allowing a tax credit against income tax for contributions to a state charitable fund would be treated under the Internal Revenue Code.
The IRS looked at these actions as quid pro quo because the intent to shift the placement of entries on Schedule A from itemized deductions with a specific cap (SALT) to charitable deductions that are far less restrictive basically negated it within the meaning of charitable contribution.
Although this is just a proposal and might change prior to the issuing of final guidance, the proposed guidance gives the IRS intent. A summary of the guidance follows:
- Will to apply to contributions after Aug. 27, 2018
- IRS is accepting comment on the proposed regulation until Oct. 11, 2018
- A taxpayer who makes payments or transfers property to an entity eligible to receive tax deductible contributions must reduce their charitable deduction by the amount of any state or local tax credit the taxpayer receives or expects to receive. Consequently, the amount they can itemize on Schedule A for charitable contributions is directly reduced by the state tax credit amount, negating the intent of these programs that were meant to circumvent the SALT cap.
- This reduction does not apply to dollar for dollar state tax deduction as these were not considered a substantial benefit to the taxpayer.
- De minimis exception is provided for state tax credits that do not exceed 15 percent of the payment or fair market value of the property. The credits below this threshold are not subject to a reduction.
States that have enacted charitable deduction workaround
Connecticut: Signed in May, the law would allow charitable contributions to municipality-created charitable organizations in return for property tax credit.
New York: Signed in April, the law would allow charitable contributions to two, new state charitable funds that support healthcare and education and the taxpayer may take a tax credit up to 85 percent of the contribution. Additionally, school districts and local governments could create charitable funds. Taxpayers contributing to these funds would receive a property tax credit equal to a percentage of the donation.
New Jersey: Signed in May, the law would allow a property tax credit equal to 90 percent of charitable deductions to funds established by local governments (municipality, county, or school district).
Oregon: Signed in April, the law would allow a tax credit for contributions to the opportunity grant fund.
Other states such as Illinois and California considered similar programs, but given the recent guidance, these would be futile efforts if the intent was to allow taxpayers to circumvent the SALT cap.
Casualties of guidance pre-TCJA state programs
Prior to the passage of the TCJA, more than 30 states had some form of tax credit for contributions to state charitable funds. The current IRS proposed guidance does not distinguish between programs that existed prior to these robust changes in tax policy and those established after. It was the IRS’s opinion that such guidance was unnecessary prior to the SALT cap because there was not a significant benefit to the individual for contributing to the fund. The amount of the contribution was moved from one itemized deduction to another. It should be noted that individuals subject to the alternative minimum tax did realize a benefit from this shift even prior to the TCJA.
IRS clarifies business deduction to charitable program might still be available
The IRS clarified the proposed regulation does not have any effect on the deductibility of such business-related payments to charities if those payments qualify as ordinary and necessary business expenses.
Other states’ SALT workaround
New York optional payroll tax: This allows employers to opt in to a new payroll tax, Employer Compensation Expense Program (ECEP). The optional tax will be phased in over three years, starting Jan. 1, 2019. Employers must opt in by Dec. 1, 2018, and then on each subsequent Dec. 1 if they want to continue annual participation.
In 2019 the annual, per-employee ECEP tax will be 1.5 percent (increasing incrementally by 2021 to 5 percent) of wages of more than $40,000. Covered employees will be eligible for a tax credit. The bill states explicitly that state employers cannot "deduct from the wages or compensation of an employee any amount that represents all or any portion of the tax imposed."
Connecticut pass-through entity tax: This new tax on pass-through entities (PE) has a subsequent credit against state taxes for partnerships (including LLCs treated as partnerships) but excluding publicly traded partnerships and S corporations (including LLCs treated as S corporations). In general, the PE tax is 6.99 percent on Connecticut-sourced income. The partners or shareholders receive a state tax credit for their pro rata share of the amount paid in PE tax.
The IRS stated in the precursor to proposed guidance in notice 2018-54 that taxpayers should also know that the U.S. Department of the Treasury and the IRS are continuing to monitor other legislative proposals to ensure that federal law controls the characterization of deductions for federal income tax filings. While the notice and subsequent proposed guidance specifically targeted the direct credit of state tax payments for contributions to state charities, it is unknown how the IRS will apply the stated principle to other SALT workarounds that essentially trade one tax for another.
With no mention in the current guidance on these types of arrangements, more states might experiment with moving state income tax into payroll or other mandatory taxes that are deductible from federal income taxes.
States file suit challenging the constitutionality of SALT limitation
In July, four states – Connecticut, Maryland, New Jersey, and New York – jointly filed suit against the federal government over the SALT limitation. The claim asserts the federal government has overstepped its authority under the 10th and 16th amendments of the Constitution, in which the federal tax power interferes in the states’ right to make choices in how to invest in their constituents. A protracted path through the court system awaits this suit.
As states develop programs to re-characterize taxes in ways seen beneficial to their constituencies, employers might have choices or requirements that vary by geography. In general, these policies are meant to minimize federal tax liability, so it might impact employer withholding at the federal and state levels. We will monitor future IS guidance and any state proposals that will impact employer withholding.