The recent Tax Cuts and Jobs Act includes many sweeping tax law changes, some of which left taxpayers scrambling at the end of 2017 to maximize tax saving opportunities. While the dust settles on tax reform at the federal level, the whirlwind at the state level is just beginning, with many unanswered questions. We’ve pulled together a look at key changes in place or under consideration in a number of states.
One change in particular, the limitation on the individual itemized deduction for state and local taxes, resulted in many making a mad dash to prepay local property taxes.
Prior to the act, itemizing taxpayers could deduct certain state and local taxes, including property taxes, income or sales taxes (but not both), and other personal property taxes. The new act limits the state and local property tax deduction to $10,000. The increase in the standard deduction makes this irrelevant for many taxpayers, who will no longer itemize deductions due to the higher standard deduction. However, this limitation means more to higher-income taxpayers, especially those living in high-tax states. Many of these states are considering strategies to preserve the deduction for high-income residents.
The California approach
One strategy under consideration by states (including California, Illinois, and New Jersey), is to convert state and local tax expense, limited to $10,000, into deductible charitable contributions. Some proposals involve creating a state fund for public purposes that would allow income tax credits for taxpayers’ fund contributions. In New Jersey, the state senate voted to advance a bill that would allow local municipalities to set up charitable funds to which residents could donate their property taxes. While this may seem like a great solution, it seems unlikely taxpayers achieve the intended result.
Established case law and guidance indicate the portion of a charitable contribution for which a benefit is received is not deductible. The very intent of this strategy is to create a federal benefit to the taxpayer. The taxpayer’s state cash outflow would be neutral, and a federal benefit received in excess of any cost. It appears likely the IRS would find there is no net deductible charitable contribution, and given the revenue neutrality for the state, would see it as a tax.
The New York approach
Other states, including New York, have considered creating a new employer-side payroll tax, or otherwise shifting from an employee paid tax system to an employer paid tax system. This may be more viable than the charitable contribution strategy, but isn’t without its own hurdles. There is a risk that this just shifts tax burden, with the employer paying the employee’s income taxes (which in itself constitutes taxable income).
States with graduated tax rates would face a challenging task of addressing how to administratively apply this concept to a payroll tax. If successful, businesses would have increased employment costs, unless they can reduce salaries to offset the increase. The practical challenges present additional obstacles for success, in terms of employee morale, minimum wage issues, or other legal considerations. Even clearing the hurdles only addresses the issue as it relates to wage income, with other sources of income left behind.
This is less concerning in states with lower or no individual income taxes. These states often rely more heavily on sales taxes or entity level business taxes for revenue. While it is a much larger change for states to implement, there may now be more incentive for states to consider their own tax reform strategies.
How states address the additional burden placed on its residents, especially those in high tax jurisdictions, is only one. Many states' tax codes piggyback off of the federal rules, and states will have to consider how, or if they will conform to the federal changes, and to what degree. Until they address these issues, taxpayer uncertainty remains. If you have questions about the new law and how it affects your business, please contact me.