States continue to pursue workarounds to the federal Tax Cuts and Jobs Act $10,000 state and local tax (SALT) deduction limitation. State attempts at circumventing the SALT cap include:
- Creation of state sponsored charities designed to convert state and local taxes to charitable contributions;
- Enactment of pass-through entity level taxes;
- Use of employer payroll tax; and
- Lawsuits brought against the federal government.
The federal government responds with challenges to these plans in various ways, such as:
- Issuing regulations intended to shut down charitable SALT deductions;
- Providing IRS statements indicating disallowance; and
- Filing motions to dismiss lawsuits.
How Have States Responded to the SALT Cap?
Several states have proposed or enacted legislation to get around the $10,000 SALT cap.
Final Regulations Defeat State Government Charitable Deduction Workaround
A popular SALT deduction workaround would have allowed a taxpayer to make a charitable contribution to a state or local government fund and receive both a state income tax credit for the donation and a federal charitable contribution deduction.
To prevent taxpayers from getting around the SALT deduction limits, the IRS issued final regulations requiring taxpayers to reduce the amount of any charitable contribution deduction by the amount of any SALT credit received or to be received in return. So, if a taxpayer makes a payment or transfers property to a Code Sec. 170(c) entity, the taxpayer must reduce any charitable contribution deduction for federal income tax purposes for any SALT credit received or expected to be received in return.
Under the final regulations, a taxpayer is generally not required to reduce the charitable contribution deduction for state or local tax deductions received. But the taxpayer must reduce the charitable contribution deduction if he or she receives or expects to receive state or local tax deductions in excess of the taxpayer’s payment or the fair market value of property transferred.
Fifteen Percent Exception
The regulations do, however, provide that a taxpayer is not required to reduce the charitable contribution deduction if the SALT credits received as a return benefit do not exceed 15% of the taxpayer’s charitable payment. The 15 percent exception applies only if the sum of the taxpayer’s SALT credit received or to be received does not exceed 15% of the taxpayer’s payment or fair market value of the property transferred.
Finally, a safe harbor has been provided to certain individuals to treat any disallowed charitable contribution deduction under this rule as a deductible payment of taxes under Code Sec. 164.
Applicability of Final Regulations
The final regulations and the safe harbor apply to charitable contribution payments made after August 27, 2018.
States Enact Pass-Through Entity Level Taxes
Another state legislative approach involving the use of a pass-through entity (PTE) level tax is attracting heightened interest now that the charitable deduction workaround has been curtailed. The PTE level tax attempts to circumvent the SALT cap by shifting state taxes from individuals to pass-through entities (PTEs) and allowing the owners to claim a credit on their state tax return for the owner’s distributive share of taxes paid by the PTE.
Generally, the PTE deducts the entity’s state and local income taxes as a tax on the business at the federal level, followed by a deduction for the PTE tax in the distributive share of the PTE owners’ income. The owner is commonly permitted to claim a credit, or allowed to exclude their distributive share of the PTE’s income, on the state income tax return for the amount of the owner’s distributive share of the taxes paid by the PTE.
Example: Connecticut Enacts PTE Level Tax
Connecticut enacted a PTE level tax in 2018. Connecticut imposes a 6.99% entity level income tax on most PTEs in Connecticut. Owners of PTEs are entitled to a credit against their Connecticut personal income tax equal to 93.01% of the PTE owner’s pro rata share of the PTE level tax paid by their PTE. Additionally, Connecticut grants a resident owner of a PTE a credit for any entity level tax imposed by other states that the Connecticut Department of Revenue Services determines is like the Connecticut PTE level tax.
Other states, such as Oklahoma, Wisconsin, New York, Arkansas, Louisiana, Michigan, and Minnesota, have enacted PTE level taxes as possible workarounds, or considered it.
IRS Acknowledges Use of PTE Level Taxes
So far, the IRS has not issued any guidance on the use of PTEs to circumvent the SALT cap, even though the recently released regulations on charitable deductions acknowledge the use of such measures.
New York Creates an Employer Payroll Tax
New York enacted a new payroll tax, called the optional employer compensation expense tax. The new tax provides a way for employers to potentially help their employees offset the SALT deduction limit. Employers electing to participate in the program would pay an entity-level compensation expense tax, with employees receiving corresponding credits to offset their individual income taxes.
Employers have been advised to proceed with caution in deciding whether to opt in to the new tax. One important consideration is that the IRS has not yet confirmed how it will treat the tax, including employer deductions. Reports indicate that few employers have opted in so far.
States Bring Lawsuits Against the Federal Government Over the SALT Cap
New York has been joined by New Jersey, Connecticut, and Maryland in suing the Trump Administration for violating the 10th Amendment. In State of New York, et al. v. Mnuchin, et al., the plaintiffs allege that the $10,000 cap on SALT deductions interferes “with the States’ sovereign authority to make their own choices about whether and how much to invest in their own residents, businesses, infrastructure, and more — authority that is guaranteed by the Tenth Amendment and foundational principles of federalism.” The plaintiffs ask that the law be overturned.
Attorneys for the United States Department of Treasury and IRS filed a motion to dismiss the complaint.
Where Do Taxpayers Go from Here?
Now that the charitable deduction workaround has been officially disallowed, it remains to be seen which, if any, attempts to circumvent the SALT cap will prove to be successful. The PTE level tax legislation shows promise, according to some tax professionals. Although one drawback is that it only benefits owners of PTEs. No doubt this area will continue to receive attention from taxpayers and the federal government alike.
By Tralawney Trueblood, J.D., M.B.A.