The Tax Cuts and Jobs Act of 2017 (TCJA) included a $10,000 cap on state and local tax (SALT) deductions. That cap has led New York and other states with high taxes to attempt to mitigate the impact of the limitation. As several states have moved to enact their own workarounds to this cap, the U.S. Treasury Department and the IRS have responded by issuing proposed regulations with the clear purpose of challenging or shutting down the state efforts. Given the evolving legal complexity that has arisen from this federal-state struggle, CPAs need to be vigilant and aware of the interplay between state-level efforts and new federal regulations in order to properly advise clients on the alternatives.
On August 23, the IRS issued pronouncement IR-2018-172, the purpose of which was to describe proposed federal income tax regulations that would address various attempts by states to utilize charitable contributions as a means to work around the federal limitation on the SALT deduction. In this context, IR-2018-172 sets forth three rules, detailed below. The rules are guideposts for taxpayers to use when determining the amount that can be deducted as a charitable contribution on their federal income tax returns when those contributions are to be used by states as credits against SALT obligations.
If the contribution qualifies as charitable contribution and the taxpayer receives, or expects to receive, a SALT credit for all or a portion of the charitable contribution, the charitable contribution deduction is the amount contributed less the credit.
De minimis rule.
If the contribution qualifies as a charitable contribution and the taxpayer receives a SALT credit that is less than or equal to 15% of the state or local tax obligation, the entire charitable contribution can be deducted.
If the contribution qualifies as charitable contribution and the taxpayer receives a SALT deduction that is equal to 100% of the SALT obligation, the entire charitable contribution can be deducted.
Although these rules may appear relatively simple, in practice the application is more complicated. The following analysis may be of assistance to tax advisors when applying these rules.
On April 18, New York enacted S. 7509, which contained two workarounds using the charitable contribution approach. The first created a state-operated charitable contribution gift trust fund; taxpayers donating to this fund would receive a state tax credit equal to 85% of the donation amount in the following year. In conjunction with recent IRS guidelines, the 85% state tax credit limitation will only allow taxpayers to claim 15% of charitable contributions on their federal income tax returns per the general rule discussed above.
The second workaround authorizes local governments to create charitable organizations that taxpayers can donate to in exchange for property tax credits. Currently, local government bodies have not issued guidance regarding any property tax credit percentage limitations; thus, taxpayers can claim the entire charitable contribution amount paid to the local government in lieu of a property tax deduction, pursuant to the dollar-for-dollar exception.
The other option that New York has provided allows employers to remit payroll taxes on behalf of their employees (1.5% in 2019, increasing to 5% in 2021 and thereafter); this takes advantage of the fact that the SALT deduction limitation is not applicable to businesses. Starting on January 1, 2019, employers can opt into the new Employer Compensation Expense Program to remit a payroll tax on the employee’s annual wages of $40,000 or more. Employers who desire to participate in this program must make the initial election by December 1. The benefit of this program might not seem clear at first, because employers might reduce the employees’ wages by the payroll tax, but the theory is that lower income taxes will be paid at the federal and state level on wages and the reduction in wages might equate to the amount lost due to the SALT deduction limitation.
In May, Governor Phil Murphy signed into law P.L. 2018, c.11. Under this law, New Jersey municipalities may create charitable funds that taxpayers can donate to and claim 90% of the donated amount to reduce their property tax bills. The 90% figure would, however, be considered a credit, and per the general rule described in IR 2018-172, taxpayers would only be allowed to claim 10% of the charitable contribution as a deduction on their federal returns. In response, New Jersey issued LFN 2018-23 on September 24, revising the property tax credit structure to allow taxpayers that donate to the municipal charitable funds to claim 15% or less of the donated amount against their property tax obligations. This new pronouncement allows New Jersey residents to deduct 5% more as a charitable contribution on their federal returns because it qualifies for the federal de minimis rule.
As several states have moved to enact their own workarounds to this SALT cap, the U.S. Treasury Department and the IRS have responded by issuing proposed regulations with the clear purpose of challenging or shutting down the state efforts.
In May, Connecticut enacted two SALT workarounds under Connecticut Substitute Bill SB 11. The first workaround grants a property tax credit when the taxpayer donates to a designated community-supporting organization, with the property tax credit being limited to the lesser of the amount of the property tax obligation or 85% of the donated amount. Because Connecticut provided two credit options, residents may elect to obtain a benefit equal to 100% of the charitable contribution, under the dollar-for-dollar rule, or 15% under the general rule.
The other option is a program that will impose a 6.99% tax on pass-through entities, S corporations, or partnerships, based on separately or nonseparately stated items that flow to the equity holders. Each equity holder will receive a state tax credit equal to its share of the tax.
Action and Reaction
The TCJA’s $10,000 federal cap on SALT deductions will have the greatest impact in high-tax states, and those states have acted to reduce the potential impact on their taxpayers. New York, New Jersey, Connecticut and other states have tried to circumvent the SALT limitation. Whether the method is creating charitable contribution funds to contribute to in lieu of paying state and local taxes, employer-level payroll tax payments, or entity-level taxes on pass-through entities, the IRS has clearly shown its willingness to respond. As an area of tax law, solutions to the SALT limitation will continue to evolve, and CPAs should closely monitor these developments to properly advise affected taxpayers.