The Planner's Perspective: SALTy StatesSubmitted by US Wealth Management New Haven on October 9th, 2018
By Paul Morrone CFP®, CPA/PFS, MSA
The Tax Cuts and Jobs Act which passed at the end of 2017 drew a hard line in the sand regarding the deductibility of certain state and local taxes. The $10k limit has been a bone of contention between many ‘blue’ states that often have higher income and property taxes than states that have historically been deemed ‘red’ states (whose representatives also control the House and Senate – those instrumental in the passage of the Act). This has created tension between state regulators and the federal government and has driven some states to take proactive (but not necessarily effective) action. In an attempt to mitigate the new tax burden on their residents, states have implemented workaround strategies that are now in effect in an attempt to circumvent the SALT deduction caps. The big question is, will it work for you?
In August of 2018, the IRS issued proposed regulations, some specifically addressing these state-led initiatives. Their overall approach has placed emphasis on ‘substance over form,’ and in simple terms says that if it looks like it’s designed to circumvent the new federal rules, then it will probably be disallowed or significantly limited. Below are a few of the items that have been designed and implemented by the states, and where the proposed regulations stand on those issues:
Municipal ‘charities’: Several blue states have authorized the creation municipal charities to accept donations from residents. The theory is that contributions to the ‘charity’ would no longer be classified as tax payments, but instead, would be considered a charitable donation which generally has much more liberal deducible caps. In exchange for these payments, residents will receive a state tax credit of a certain percentage (approximately 90% depending upon the state) of their donation, thereby offsetting the amount they owe to the state by almost a 1:1 ratio. To color within the lines, states could not offer a dollar-for-dollar offset in the tax liability as this would simply be deemed a tax by regulators and therefore would, again, fall under the $10,000 cap.
Will it work? Partially. The proposed regulations addressed this issue specifically, much to the chagrin of the states that spend the time and effort to implement this strategy. The IRS has taken the stance that only a portion of the donation could be considered a charitable donation for federal income tax purposes. For example, if you make a $20,000 donation to your state’s municipal charity and receive a 90% credit against your state tax liability (a $18,000) credit, then only $2,000 (the remaining 10% which you did not receive a state tax incentive for) will qualify for the federal charitable deduction on your 1040. Unfortunately for many, even large donations (because of the state tax credit offset), will generate only small qualifying charitable donations.
Business Entity Income Taxes: Some states, such as Connecticut, have enacted a new business entity income tax on passthrough entities (partnerships and S-Corps) which taxes income at the maximum state rate of 6.99% at the entity level. In exchange, each partner of the entity will receive a state tax credit of 93.01% directly against their state tax liability. The state believes that by assessing tax at the entity level, it would be deemed by the IRS an ordinary cost of doing business and therefore be deductible on the federal 1065 or 1120-S, ultimately reducing the amount of income passed through to the individual partner by the amount of tax paid by the entity on their behalf.
Will it work? Probably not, and it certainly angered many residents and inadvertently increased many business owners’ tax burdens. The IRS has already stated that deductions of state income taxes paid is not deductible as an ordinary and business expense under section 162 of the treasury regulations. This has always been the case under federal law. Many CPAs in the state of CT are awaiting final guidance from both the IRS, State Department of Revenue service and State Society of CPAs as to how to advise clients as whether these taxes will ultimately be deductible. In addition to the increased compliance costs and complexities, the law was proposed in May of 2018 with an application retroactive to January 1, 2018. This means Connecticut business owners are required to comply with the new rules in their 2018 income tax filing.