U.S. Treasury & IRS to Address State Tax Deduction ‘Workarounds’

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 contribute. 

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.

Related: U.S. Internal Revenue Service Updates Standard Mileage Guidance for 2018

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 workaround.

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.

How This Will Impact Mobility

This issue will affect organizations with employees in high tax states, whose federal tax liabilities will be uncertain until the issue is resolved.

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