Understanding the new limitation: Sec. 164(b)(6)
Prior to the TCJA, Sec. 164(a) allowed individual taxpayers an itemized deduction for state and local income, real property, and personal property taxes. For tax years from 2018 through 2025, the TCJA created Sec. 164(b)(6), which prohibits individual taxpayers from deducting more than $10,000 in state and local taxes ($5,000 in the case of a married taxpayer filing separately). This limitation only applies to taxes not incurred in a taxpayer's trade or business.
Initial response: Prepayment of state and local real property taxes
Immediately after the TCJA was enacted on Dec. 22, 2017, tax practitioners began looking for planning opportunities to assist their clients. The initial response was for taxpayers to prepay their taxes before the end of 2017 to receive the tax benefit before the limitation went into effect on Jan. 1, 2018.
Congress anticipated this initial workaround regarding income taxes and included the following language in Sec. 164(b)(6):
[A]n amount paid in a taxable year beginning before January 1, 2018, with respect to a state or local income tax imposed for a taxable year beginning after December 1, 2017, shall be treated as paid on the last day of the taxable year for which such tax is so imposed. [emphasis added]
However, no such statement was included for real property taxes, thus seeming to allow a deduction for prepaid real estate taxes. Certain states' governors issued executive orders allowing local governments to accept prepayments of 2018 real property taxes, anticipating that the specific silence as to real property taxes would allow their residents a federal deduction.
Prepayment of real property taxes: Harsh reality
On Dec. 27, 2017, the IRS issued an advisory statement asserting that states were required to take action not only to permit the prepayment of taxes but also to ensure the assessment date of such taxes occurred in 2017 for any deduction for prepaid taxes to be valid. This means that residents of states that allowed prepayment of real property taxes that were not assessed in 2017 would not qualify for a federal deduction. Pursuant to statements made by Treasury Secretary Steven Mnuchin, audits of some tax returns should be expected, targeting states that allowed the prepayment of real property taxes without legislatively amending the assessment dates.
On March 5, 2018, a group of congressional representatives sent IRS Acting Commissioner David J. Kautter a letter stating that the IRS was "inventing restrictions" that were "not authorized by Congress" and requesting information on the potential audit liability in high-tax states. Although the members of Congress requested a response by March 16, 2018, no response had been issued as of this writing.
Pursuant to Mnuchin's statements and Kautter's subsequent silence, residents in high-tax states should review the assessment procedures within their state to determine the availability of any prepaid real property tax federal deduction.
Even if the IRS allowed a federal deduction for the prepayment of state and local real property taxes, that deduction may have no economic benefit to taxpayers subject to the alternative minimum tax (AMT), as that type of deduction is added back for the AMT calculation.
High-income-tax states' resolutions
In 2018, high-income-tax states began formulating long-term solutions around the $10,000 state and local tax deduction limitation. Governors in high-tax states such as Maryland, New Jersey, and New York have indicated they are exploring legal options to block the federal government from implementing the deduction limitation. However, legislative proposals are being introduced with the intent to "hold harmless" residents living in high-tax states through swapping income taxes with different revenue-raising strategies that would allow an unlimited federal deduction. The most prevalent workarounds include charitable donations to state funds, elective payroll taxes, and entity-level taxes on passthrough businesses.
Many states are considering or have created charitable contribution funds that resident taxpayers may contribute to in lieu of paying state and local taxes. The legislation allows for donations to the state funds to produce a federal charitable deduction on the resident taxpayer's federal income tax return. This would allow the state to collect its full tax revenue and allow taxpayers to reduce their federal tax liability via a larger charitable contribution deduction.
Legal ramifications: The idea that a taxpayer may make a donation to a state government program and receive a federal deduction is not new. Before the TCJA, many states included the option for donations to state programs such as school tuition scholarship programs and natural resource preservation that allowed a state tax credit and federal deduction.
Sec. 170(c)(1) allows a federal deduction for charitable contributions, which include donations to a state, a possession of the United States, or any political subdivision of any of the foregoing, or the United States or the District of Columbia, but only if the contribution or gift is made for exclusively public purposes. Generally, the amount of the federal deduction available is limited to the amount of cash paid and the fair market value (FMV) of any property (other than cash) transferred by the taxpayer, reduced by the FMV of any goods or services the taxpayer receives in return.
Under case law and IRS rulings, the tax benefit of a state charitable contribution, whether a state credit or deduction, is generally not regarded as a return benefit that reduces the federal deduction. For example, in Tempel, 136 T.C. 341 (2011), the Tax Court ruled that a state tax credit is not an accession to wealth that results in income, and the transfer of state tax credits does not represent a right to receive income from the state.
In opposition to the long-standing principle that a federal deduction is allowable for state charitable donations, the IRS has indicated that the proposed charitable donation workaround may create a quid pro quo donation resulting in potential tax evasion. The federal government generally views tax transactions through the lens of substance over form. This means that, although the payment benefits the public, if the payment lacks "charitable intent" and the sole purpose of the transfer is financial gain (i.e., reduced taxes), the federal deduction may be eliminated. The IRS has, in fact, indicated it plans to challenge these state workarounds. In Notice 2018-54, the IRS announced that it intends to issue regulations applying a substance-over-form analysis to these payments, suggesting that they will not be treated as bona fide charitable contributions.
California: The California Senate in January passed S.B. 227, establishing a California Excellence Fund and providing taxpayers with a state tax credit for contributed amounts. However, on June 4, 2018, following the IRS's issuance of Notice 2018-54, the California Senate amended S.B. 227 to more closely mirror existing IRS-approved programs. Rather than donations to a general fund, the amended bill instead allows taxpayers to donate to a new Local Schools and Colleges Voluntary Contribution Fund to benefit education. The fund will accept contributions from residents in lieu of state and local income taxes, providing residents with an 85% tax credit in California for contributed amounts.
Connecticut: On May 31, 2018, Gov. Dannel Malloy signed S.B. 11, which provides a property tax credit for donations to a community-supporting organization that provides support for public programs and services. Effective July 1, 2018, each municipality must annually approve the property tax credit and determine the amount of the credit, which must not exceed the lesser of the amount of property tax owed or 85% of the amount of the donation.
On May 2, 2018, the Connecticut Senate passed S.B. 414, which creates the Citizens in Need Account. This fund is intended to provide assistance to residents who have their social services program benefits reduced due to budgetary constraints. Taxpayers contributing to the fund would receive a state deduction at the rate of 200% of the amount contributed.
Illinois: As of this writing, the Illinois House of Representatives is negotiating H.B. 4237, which would create the Illinois Education Excellence Fund. This fund would accept contributions from residents in lieu of state and local income taxes, providing residents with a tax credit in Illinois. Additionally, contributions to a county treasury would produce a property tax credit.
New York: On April 18, 2018, New York became the first state to change its tax code to provide relief from the state and local tax deduction limitation when Gov. Andrew Cuomo signed into law S. 7509. The bill creates two new charitable contribution funds for health care and education. Similar to the California Excellence Fund, taxpayers may receive a state credit of up to 85% of their contributions.
New Jersey: On May 4, 2018, Gov. Phil Murphy signed into law S. 1893, which authorizes any municipality, county, or school district to establish a charitable fund for specific purposes that would accept donations and to provide a property tax credit of up to 90% of a donation to the fund.
Some states are considering converting a portion of the state income tax into an elective employer-paid payroll tax with an employee wage credit. Essentially, employers may elect to pay an excise-type payroll tax on the aggregate amount of their wages rather than have the employees pay state income tax. The payroll tax would be funded through a reduction in the employee's compensation. The employer should receive an unlimited payroll deduction, which remains unaltered by the TCJA; the employee receives a credit and therefore is not subject to personal income taxes, and the employee's income is thereby reduced for federal income tax purposes.
This workaround is expected to be revenue-neutral to the states because the payroll tax collected should be offset by the reduced personal income tax collected.
Legal ramifications: Analysts agree that a new payroll tax may pass IRS scrutiny. Unlike the charitable donation workaround, this plan is not recasting a tax as a deduction. Rather the state is shifting the tax to another taxpayer, in this case the employer. However, the IRS may view the corresponding employee credit as the employer's making income tax payments on the employee's behalf, depending on the specific drafting of the legislation.
For many employers, the day-to-day application of this workaround may be more burdensome than the benefit received is worth. For example, determining the proper amount of wage reduction for different types of employees (i.e., salary vs. hourly, and different pay levels) may be difficult. Moreover, out-of-state workers may end up paying more tax due to the loss of any corresponding income tax credit in their resident state for taxes paid to the employment state. For example, an employee who is a resident of Connecticut but works in New York would not receive a Connecticut income tax credit for the payroll taxes levied in New York.
The payroll tax does not apply to all types of workers and all types of income (i.e., self-employment income and capital gains). This means the benefit of this workaround would not reach as many taxpayers as the charitable donation workaround.
State legislation: New York: S. 7509 also created a voluntary payroll tax system that employers may opt into known as the Employer Compensation Expense Program. Once an employer opts into the system, it would pay a payroll tax (at a rate of 1.5% in 2019, increasing to 5% for 2021 and after) on each employee's annual wages of $40,000 or more, and employees would receive a tax credit "corresponding in value" to the payroll tax remitted.
Entity-level tax on passthrough entities
Some states are analyzing whether to pursue an entity-level business tax for passthrough entities to take advantage of the unlimited state and local deduction allowed through a taxpayer's trade or business. State tax on income flowing through passthrough entities to their owners is subject to the state and local deduction limitation on the owners' personal income tax returns. This workaround allows the entity to pay the tax and obtain an income tax credit that would flow to the entities' owners.
Legal ramifications: Similar to the payroll workaround, imposing entity-level taxes on passthrough entities is a concept used by many states (e.g., the unincorporated business tax in New York City, which assesses taxes on passthrough entities filing composite returns with out-of-state partners, and the Ohio commercial activity tax). Therefore, analysts have welcomed the idea of another entity-level tax, which many view as the most reasonable approach to avoid IRS concerns. In addition, states such as New Jersey, New York, and Pennsylvania currently have "dual status" provisions regarding S corporations. In these states a corporation that has made a federal S corporation election can choose to be taxed as a C corporation for state income tax purposes.
State legislation: Connecticut S.B. 11, signed into law on May 31, 2018, also created a 6.99% income tax on the net receipts of passthrough entities such as partnerships, S corporations, and limited liability companies that are taxed as partnerships for federal income tax purposes. The intention of the law is to provide the entity with a deduction under Sec. 164 for the state tax paid, which would lower the flowthrough income to the owners and avoid the limitations of Sec. 164(b)(6). Additionally, a separate individual state tax credit is issued to offset 93.01% of the state income tax the owners paid on the passthrough income. The entity-level tax is effective Jan. 1, 2018, and requires estimated payments quarterly.
While the states' intentions are to "hold harmless" their residents through these tax workarounds, it is important to remember that these avoidance schemes may lead to a federal audit with potential interest and penalties. As noted above, Notice 2018-54 announced that proposed regulations clarifying the treatment of income recharacterized for the purpose of circumventing the state and local deduction cap should be expected. The notice emphasizes the substance-over-form doctrine in determining whether the state workarounds are viable and specifically mentions the charitable deduction workaround. The application of the substance-over-form doctrine to the payroll- or entity-level tax is still unclear. Absent further guidance, the most promising workaround for the IRS to accept is likely the entity-level tax. Although the benefit of this workaround would be limited to state income taxes levied on individuals with respect to their passthrough income, it most likely would cover a large number of taxpayers whose deductions would otherwise be limited. This workaround would also significantly reduce the compliance burden of many closely held businesses that are multistate organizations; however, the treatment of state tax credits for nonresident owners/partners could be an issue in the various nonresidents' states.
As evidenced by Notice 2018-54, taxpayers should be aware that programs such as the charitable deduction with a corresponding state tax credit and other programs that provide credits for alternative payments to the state are subject to challenge at the federal level. These strategies should be reviewed with a tax adviser before they are implemented. Taxpayers should carefully weigh the pros and cons of participating in such programs.
Anthony Bakale is with Cohen & Company Ltd. in Cleveland.
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