Under the new tax code, taxpayers who itemize their deductions will be subject to a cap on state and local tax (SALT) deductions. States with higher individual income and property tax rates have objected to this cap and have created tax maneuvers to avoid the new limit.
The 2017 Tax Cuts and Jobs Act limits an individual’s deduction for SALT to $10,000. Any state and local individual income or property tax payments in excess of that amount will no longer be deductible.
New York, New Jersey, and California are some of the states attempting to use charitable contributions as a workaround to the new federal limit.
“One idea is to set up charitable trusts for education or general welfare purposes so that taxpayers can reduce their property tax liability by making a contribution to the charitable trust,” said Steven Ebert, a partner at Barton LLP, a New York-based law firm.
“Conceptually, when you donate to a charity, you can receive a tax write off,” he added.
The Internal Revenue Service (IRS), however, warned it would not tolerate states trying to skirt the federal limit. On May 23, the IRS issued a notice on state and local tax deductions and advised taxpayers to proceed with caution.
“Despite these state efforts to circumvent the new statutory limitation on state and local tax deductions, taxpayers should be mindful that federal law controls the proper characterization of payments for federal income tax purposes,” the IRS stated in the notice.
Treasury Secretary Steven Mnuchin earlier rebuked states that were looking for loopholes.
“It’s one of the more ridiculous comments to think that you can take a real estate tax that you’re required to make, and dress that up as a charitable contribution,” he said at a White House press briefing in January.
“I hope that the states are more focused on cutting their budgets and giving tax cuts to their people in their states than they are on trying to evade the law.”
New York was the first state to create a SALT deduction cap workaround.
Gov. Andrew Cuomo claimed the SALT limitation will cost New York taxpayers $14.3 billion. He signed legislation on April 17 that provides new options for tax-deductible charitable contributions. Under the new law, the state-operated charitable funds permit taxpayers to claim a state tax credit of 85 percent of the donation to health care and education funds.
The California State Assembly is considering two bills aimed at the SALT limitation. Similar to New York, both bills would allow an individual income tax credit of 85 percent of contributions to the California Excellence Fund.
On May 4, New Jersey Gov. Phil Murphy signed into law a workaround bill that allows taxpayers to contribute to a municipal or school district charitable fund and get a credit on their property tax bill of up to 90 percent of the donation.
Additionally, Illinois, Connecticut, and Rhode Island have related legislative actions in progress to skirt the federal deduction limit.
States claim that they are not creating a tax loophole. This charity contribution mechanism has been in place and operating with no IRS objection for years in states like Missouri and Arizona.
Ebert, however, believes that there is a problem with the new charity contribution workarounds. The IRS is highly unlikely to approve the new structure, as the so-called contributions do not bear the hallmarks of genuine charity.
“That’s going to be a very big political debate,” he said.
When they donate, taxpayers are getting a corresponding reduction in property taxes. According to IRS regulations, taxpayers cannot deduct as a charitable contribution any payment for which they receive a benefit in return.
So the counter argument from the IRS and the federal government would be that the states are trying to “create a loophole, not a real charity with donative intentions,” he said. “That’s going to be the tension.”
Despite the state efforts to circumvent the new cap on state and local tax deductions, the IRS warns taxpayers to be mindful that federal law controls the proper characterization of payments. Hence, while state governments will create their own standards, the IRS has the right to audit individual taxpayers and as a result, taxpayers may end up “fighting with the federal government by themselves,” Ebert said.
“This will potentially be very, very messy,” he said, adding that individual taxpayers will be caught between the federal and state authorities.
It is hard to know how the states and the federal government will settle the conflict, but millions of households may fall into this situation. Hence, instead of going after individual taxpayers, the federal government should seek to have a broader negotiation with states, he said.
In 2015, the average New Yorker’s SALT deduction was more than $22,000. In New Jersey and California, those deductions were nearly $18,000.
Income Tax Deduction
In addition to charitable donations, states like New York are devising mechanisms that allow statewide payroll taxes to be paid by employers.
States are “talking about partially switching from a state income tax to a payroll withholding paid by the employer,” Ebert said.
By shifting the income tax from an itemized deduction on the personal return to a business expense on the business return, he explained, the states would solve the SALT limitation problem as businesses are not capped on ordinary and necessary business expense deductions.
“The states would be in a strong position with the payroll tax withholding vis-a-vis the federal government as to any limit, but would now have a new problem,” he argued.
The employers have to come up with extra dollars to offset the loss and so may have to negotiate with employees to reduce their compensation, which would be a logistical nightmare, he said.
The Treasury Department has not provided much guidance on this matter. The states are still contemplating this, but at the end of the day, it’s a private decision by the businesses, said Ebert.
The Tax Cuts and Jobs Act, which was signed into law on Dec. 22, 2017, narrows itemized deductions to simplify the tax code. However, it nearly doubles the standard deduction for individuals from $6,350 to $12,000 and for married couples filing jointly from $12,700 to $24,000.
It also reduces the individual tax rates but keeps the existing seven tax brackets. Under the new law, the individual tax rates are set at 10 percent, 12 percent, 22 percent, 24 percent, 32 percent, 35 percent, and 37 percent.
The new code expands the child tax credit from $1,000 to $2,000 for both individuals and married couples filing jointly.
Many individual income tax provisions, including the child tax credit, will expire by the end of 2025, and the old rules will take effect unless the provisions are extended.
According to Republican leaders, tax reform will simplify tax filing and enable 9 out of 10 people to fill their taxes on a single sheet.