In a Notice issued 23 May 2018, the U.S. Treasury and
Internal Revenue Service (IRS) announced their intent to issue regulations
addressing state efforts to “work around” the new limitations on deductions
for state taxes enacted as part of the Tax Cuts and Jobs Act (TCJA).
The TCJA limits individual itemized deductions for all state
taxes (income, property, sales) to $10,000, beginning in 2018. Under prior law,
such deductions were unlimited. The new limitations adversely affect taxpayers
in high tax states. A number of such states have reacted by considering or
enacting provisions that would effectively convert the taxes to forms of levies
that remain fully deductible.
New York and New Jersey have done so, and legislation has
passed the state legislature in Connecticut. Rhode Island and Illinois are
actively considering such legislation.
Although both the New York and Connecticut laws include
provisions imposing an entity level tax on passthrough businesses (which would
remain deductible by the business), with an offsetting credit at the individual
owner level, the primary focus of workaround legislation has been to create
state or local charitable entities to which individual taxpayers may
Taxpayers get a state income or property tax credit for the
contributions. The states maintain that the contributions are fully deductible
for federal income tax purposes as charitable contributions. New Jersey’s new
law includes the charitable contribution workaround strategy, as do both New
York and Connecticut.
As these plans have gone forward, the Treasury Department
and IRS have repeatedly voiced skepticism that converting state taxes to
charitable contributions will work to achieve federal tax deductions, despite a
great deal of prior law suggesting that the strategy is permissible.
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In its new Notice, the federal government says that it will
issue proposed regulations addressing the issue. Although the Notice does not
state a position as to the deduction issue itself, it does say that “[t]he
proposed regulations will make clear that the requirements of the Internal
Revenue Code, informed by substance-over-form principles, govern the federal
income tax treatment of such transfers” and has been taken by the states to
mean that Treasury intends to try to put a stop to the charitable deduction
Reaction from the states, and many tax advisors, was swift
and very much opposed. A letter to IRS from the Attorney General of New Jersey
was typical of the reaction, urging
withdrawal of the Notice and criticizing what he considers an ill-advised
attempt to influence taxpayer behavior.
This issue will affect organizations with employees
in high tax states, whose federal tax liabilities will be uncertain until the
issue is resolved.