More and more taxpayers are beginning to feel the impact of the Tax Cuts and Jobs Act’s $10,000 cap on the federal income tax deduction for state and local taxes (SALT). As taxpayers start finalizing their tax returns previously on extension, many are seeing their federal taxes rise with the loss of the one-hundred-year-old SALT deduction.
When the SALT deduction limitation became law in December of 2017, several states responded by creating programs to help their residents circumvent the changes in the federal law. States such as New York and New Jersey took steps to get around the limitation by enacting legislation meant to convert state and local taxes into charitable contributions. Under the workarounds, taxpayers could donate to state and local government-run funds, with the proceeds being used to pay for government services that otherwise would be funded through taxes, and the contributors would receive tax credits to apply against their state and local tax liabilities. The intention was for taxpayers to then deduct the donations to these funds as charitable contributions on their federal returns, which are not subject to the SALT limitation. For example, a New Yorker with an annual state property tax of $30,000, that is reduced to a $10,000 deduction under the new federal limitation, could instead remit the monies to a government fund and (1) receive a dollar-for-dollar credit against his or/her state property taxes, and (2) claim the full $30,000 as a federal charitable contribution deduction.
These workarounds resulted in the issuance of proposed IRS regulations over a year ago barring such schemes. The proposed regulations generated more than 7,000 practitioner comments to the Treasury Department. In June, the IRS issued its final regulations determining that the receipt of state or local tax credits in return for making government fund contributions constitutes a “quid pro quo,” and thus a reduction in the amount of federal deductions a taxpayer can claim for these charitable contributions is necessary. Under the final regulations, taxpayers only receive a federal deduction for a charitable contribution that is greater than the amount of the tax credits they receive in return. This means the New Yorker who makes a $30,000 charitable donation to a municipal fund in lieu of property taxes, and receives a $25,000 state tax credit in return, will only be able to claim a charitable deduction of $5,000.
In response to final regulations, a number of state and local taxing authorities are attempting to push back. Recently, New Jersey, Connecticut and New York filed suit against the IRS and the Treasury Department over the SALT cap regulations. The village of Scarsdale, NY, on behalf of a group of other counties, municipalities and local school districts, also filed suit sighting irreparable harm to the charitable reserve funds enacted in the wake of the federal tax cut. The stakes for residents of these states and cities are incredibly high, as these localities are among the highest taxed jurisdictions in the country.
The final regulations, however, do not address all of the SALT workarounds employed by states. The most prominent example, viewed by some to at least initially survive IRS scrutiny, is the use of pass-through entity taxes. Connecticut implemented its pass-through business tax requiring income taxes to be paid at the entity level on income earned by a partnership, LLC or S Corp thereby escaping state tax at the partner level and thus not subject to the SALT deduction limitation on partners’ federal returns. As an added benefit, the entity level taxes paid are a deductible expense of the entity. It is estimated that over 110,000 pass-through entities are filing Connecticut pass-through tax returns this year, resulting in an estimated savings of $2.7 billion that otherwise would have been turned over to the IRS.
Other states are taking note of Connecticut’s workaround and are exploring their own entity level taxes, though so far only Connecticut’s tax is mandatory (likely helping to contribute to the workaround’s viability). Wisconsin, Oklahoma, Louisiana and Rhode Island have all passed elective pass-through entity taxes, and other states such as Arkansas, Michigan and Minnesota have submitted legislative proposals at the behest of their small business constituents.
In recent weeks, the IRS has indicated that it is shifting its focus to these pass-through entity taxes used as SALT limitation workarounds. It is speculated that the IRS may deem the credit that partners receive for the entity level taxes as a “quid pro quo,” much like the aforementioned contribution plans. Guidance from the Treasury Department addressing this legislation is expected soon. Until then, states like Connecticut remain confident with their SALT workaround plans knowing that the IRS has not been able to penetrate them yet.
If you have questions regarding the effect of the new IRS regulations on your taxes, please contact us.