Several high-tax states reacted to the TCJA ceiling imposed on the federal itemized deduction for state and local taxes by passing legislation to circumvent the $10,000 limitation on their residents’ state income, sales and property tax deductions.
Most notably, New York approved contributions to state-operated charitable funds allowing taxpayers to claim a state income tax credit equal to 85 percent of the donation to healthcare and education funds. The New York legislation also includes a voluntary payroll tax on employers as another way New York is attempting to provide some relief to wage earners affected by the new $10,000 federal deduction limit on state and local government tax payments. The employers are granted a state income tax credit for the payroll tax paid on behalf of its employees.
New Jersey enacted a workaround plan that permits municipalities, counties or school districts to establish charitable funds and allow donors to receive a 90 percent property tax credit in exchange for donations. Connecticut provides for an 85 percent credit against property taxes for donations made to “designated community supporting organizations.”
In 2018, Connecticut enacted a pass-through entity tax, which imposes a 6.99 percent levy on entities treated as partnerships and S corporations. Partners, LLC members and shareholders are granted a 93.1 percent credit against their Connecticut personal income tax liability for their pro rata share of the pass-through income for tax paid by the entity. Ostensibly, the tax permits pass-through entities to claim a federal business expense deduction at the entity level, shifting the incidence of the tax up from the individual partners.
In response to states’ workaround strategies, on Aug. 23, 2018, the IRS and Treasury issued proposed regulations intended to curtail them. The proposed regulations note that when a taxpayer receives a state credit in return for a payment to an entity listed in section 170(c), which includes government and private charities, that tax benefit constitutes a quid pro quo. The taxpayer must reduce the charitable deduction by the amount of any state or local credit received for the donation. Exceptions are provided for dollar-for-dollar state tax deductions and for tax credits of no more than 15 percent of the payment amount or of the fair market value of the property transferred.
The IRS said that although deductions could be considered quid pro quo benefits in the same manner, sound policy considerations warrant making an exception to quid pro quo principles in the case of dollar-for-dollar state and local tax (SALT) deductions. The proposed regulations state: “Because the benefit of a dollar-for-dollar deduction is limited to the taxpayer’s state and local marginal rate, the risk of deductions being used to circumvent section 164(b)(6) is comparatively low.”
Consequently, the proposed federal regulations allow taxpayers to claim contributions involving dollar-for-dollar SALT deductions. However, if the taxpayer receives a SALT deduction exceeding either the amount of the payment or the FMV of the property transferred, the individual’s charitable contribution deduction must be reduced.
On Oct. 11, California, Connecticut, New Jersey and New York provided comments to the IRS on the proposed regulations that effectively request they be rescinded. At the same time, Connecticut, New Jersey and New York joined with Maryland to seek an injunction in federal court against the federal government, requesting the invalidation of the $10,000 SALT deduction ceiling.
From the taxpayer side of this issue, some businesses have pursued a workaround strategy available to S corporations. A limited number of states allow federal S corporations to elect out of their “state” Subchapter S status and be treated as a C corporation. As such, the federal S corporation will pay the state’s corporate income or franchise tax. From a federal tax standpoint, the state income or franchise tax is deductible at the entity level and, therefore, not subject to the $10,000 SALT cap. States where this strategy is permissible include New York, Pennsylvania and Wisconsin. In other states, like Georgia, S corporations can trigger corporate-level tax by revoking nonresident shareholder consents to be included in a composite return or to file a Georgia personal income tax return. Careful consideration should be given to all of the state tax consequences prior to electing to be taxed as a C corporation. In Wisconsin, for example, a federal S corporation cannot re-elect state S treatment for five years if it opts into being taxed as a C corporation.
View more insights in the 2018 year-end tax planning letter >
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