Additional “Workarounds” for Federal Limit on State & Local Tax Deduction

The Tax Cuts and Jobs Act (TCJA) imposed a $10,000 limit on the federal deduction for state and local taxes.  Since that time, a number of states have enacted laws intended to circumvent the limitation.  Initial efforts typically involved setting up or designating charities to which contributions could be made and for which the contributor would receive a corresponding income tax credit.  Connecticut, New Jersey, New York, and Oregon have enacted such laws, with several other states considering them.  

The Internal Revenue Service reacted by proposing a regulation under which the federal charitable contribution deduction would be limited to the net of the contribution minus the tax credit.  The IRS received over 1,500 comments on the regulation, and a hearing was held in early November at which speakers both criticized and supported the regulation.  

In addition, four states (Connecticut, Maryland, New Jersey, and New York) sued the federal government in the U.S. District Court for the Southern District of New York alleging that the TCJA limitation is unconstitutional.   The federal government moved to dismiss the suit in early November, arguing that the states lacked standing and failed to state any valid constitutional violations.  The states have now responded with a December 14, 2018, brief alleging that the limitation is like “a gun to the head” forcing them to lower taxes and cut state programs.  Opinions in the tax community are divided as to likely outcomes of the lawsuit, although the majority believes it is unlikely to succeed.

A second type of workaround has garnered less attention but is increasingly being adopted by additional states.  

In addition to the charitable contribution workaround, Connecticut enacted a law that would impose an optional 6.99% entity-level tax on pass-through businesses, with a corresponding credit at the individual owner level.  The result is a tax fully deductible by the business at the federal level, combined with a reduction of the individual’s state taxes.  

New York enacted a somewhat similar provision that would allow employers to elect to pay a tax on wages of their employees exceeding $40,000, combined with a corresponding tax credit at the individual employee level for a percentage of the tax paid by the employer.  As of early December, some 260 businesses in New York had opted into this system.

Although no other state has yet followed the New York example, several have enacted or are considering systems that mimic the Connecticut law.  Wisconsin’s legislature passed such a law, and it was signed by the Governor on December 14, 2018.  Michigan passed such a law on December 19, 2018, and it is awaiting the Governor’s signature.  A committee of the New Jersey Senate has passed a similar bill.  And proposed bills are pending in Arkansas, California, and Iowa.

Unlike the charitable contribution workaround, the IRS has said nothing about workarounds like the entity level taxes in Connecticut and New York, and the majority view is that such programs will eventually be allowed to function, although there are several grounds on which the IRS could choose to challenge them.  In addition, there are a number of operational and other issues with such programs, some of which are addressed in a comprehensive analysis by the AICPA.    

How This Impacts Mobility

Companies are increasingly fielding questions from employees in states that have enacted or are considering workarounds about their state tax liabilities, or are being asked to consider participating in workaround programs.  Not only is the acceptance of such programs by the IRS in doubt, but their operational details present difficult problems.  In addition, such programs could affect gross-up calculations.  As a result, companies should proceed with caution.

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