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The Straight Dope on SALT Workarounds

06/16/18

The Tax Cuts and Jobs Act of 2017 (the "TCJA") brought about sweeping changes to the Internal Revenue Code. One of those changes was a $10,000-per-tax-return cap on the deduction for state and local income, sales, and property taxes ("SALT") not incurred in running a trade or business (this includes any distributions of profit from a trade or business, such as dividends from a corporation or a partner's allocable share of partnership profits).

It wasn't difficult for most residents of high-tax jurisdictions, such as my home state of New York, to figure out how detrimental this would be for them to capture the benefits of the TCJA that would inure to the rest of the country. These residents used to be able to deduct SALT without limit; now they'd be losing out on tens of thousands of dollars in federal deductions, potentially offsetting all other benefits of the TCJA (and then some, in certain cases).

The governments of these high-tax states heard their residents' plaintive cries and decided they would take action. New York kicked off festivities with three measures, two of them legislative. Quick research reveals other states have also begun to construct workarounds. As one would expect, the federal government is quite unhappy about the states' attempts to defy their main revenue-raiser in the TCJA, and the IRS issued a notice that functioned as a thinly-veiled warning to states and individual taxpayers trying to find ways to circumvent the new $10,000 cap on SALT deductions.

This leads us to the potentially multi-billion dollar question: will any of this even work? In this article, I weigh in on this crucial question. As always, none of the content in this article is tax or legal advice - procure individualized advice from your own tax advisor who considers your specific facts and circumstances before acting.

2017 Prepayments of Local Property Taxes

While only a one-time measure, many taxpayers rushed to prepay their 2018 local property taxes before December 31, 2017, which would allow these taxpayers the full and unlimited deduction before the TCJA took effect.

The IRS determined that the property taxes would have to be both paid and assessed in 2017 to be deductible in 2017, as opposed to being deductible in 2018 (and therefore subject to the $10,000 limit). For most New York taxpayers, the local tax assessors appear to have done their part in making sure 2018 property taxes were assessed in full prior to December 31, 2017 -- but if you took this measure yourself, you'll need to double-check with your local receiver of taxes.

Charitable Contributions in Lieu of Property Taxes

Recognizing that the prepayment of property taxes would only be a one-time trick to help New York taxpayers, the state legislature passed a measure allowing New York taxpayers to make a "charitable contribution" to a government-sponsored fund in order to get an offset against property taxes. Considering contributions to public charities are deductible up to 60% of adjusted gross income under the TCJA, the theory goes that taxpayers electing to make the charitable contribution will get a much higher limit than $10,000 per year to write off their property tax payments.

This scheme has several serious issues under federal tax law, and the IRS has at least three ways to attack it, all of which figure to be successful:

  1. Statutory: The charitable contribution deduction requires that the taxpayer make a bona fide donation (i.e., the taxpayer received nothing in return for the money or property donated). When a taxpayer makes a contribution to a state-sponsored fund in exchange for a credit against local property taxes, the taxpayer has not actually made a charitable donation.
  2. Regulatory: The IRS will pass regulations formalizing the aforementioned interpretation of the statute. Taxpayers would need to file a form disclosing they are taking a position against the regulations, which may make it easier for the IRS to assess penalties against anyone trying to claim these payments to state-sponsored funds as charitable deductions.
  3. Administrative Guidance: The theory that contributions to state-sponsored funds would be characterized as charitable deductions stems from this IRS Chief Counsel Advice memorandum in 2010. While laypeople may view this as a strong source of authority, tax advisors understand that such guidance is not actually binding on the IRS, and the Service can revoke or supersede the guidance anytime they wish.

My take: this state-sponsored fund play is a political stunt giving legislators, senators, and the governor a great sound bite in November (when most of them are up for re-election). By the time the incumbents are sworn back into office for another term, the IRS will drop the hammer on this strategy, and taxpayers will be out of luck.

As tough as this news might be to some readers, the state-sponsored fund strategy is a fool's errand. In the worst case scenario, it may actually backfire.

Swapping an Employee's State Income Taxes for an Employer's Payroll Taxes

The second New York legislative measure is much more interesting. Governor Cuomo also signed into law a state statute creating the ECET, a program letting employers effectively pay their employees' New York income taxes for them in the form of a federally deductible payroll tax.

Example: say I receive a gross salary of $65,000 from my employer. My New York income taxes arising from this salary are $4,000. My employer adopts the ECET, so my gross salary now decreases to $61,000, but my employer is paying my $4,000 in New York income taxes for me. I come out ahead because I can use more of my property taxes against my $10,000 limit on deducting SALT, which should also decrease my federal tax bill. My employer comes out no worse for wear because it can deduct the $4,000 it paid to New York State on my behalf as a payroll tax. The only loser in this arrangement, of course, is the United States Treasury.

The federal government is probably just as angry about this idea as it is about the state-sponsored charitable funds. However, by my count, the IRS has more hurdles to jump when trying to invalidate the ECET. As it stands, federal statute allows employers to deduct any payroll taxes assessed by a state government. The IRS would have to craft anti-abuse regulations very carefully to avoid zapping out legitimate payroll tax deductions, which would have a negative effect on employers across the country.

From the taxpayer perspective, most of the barriers to realizing a benefit from the ECET are practical, not legal. For taxpayers who aren't self-employed, they'll have to see if their employer is willing to overhaul payroll to even implement the ECET in the first place. Worse yet, employers can't implement the ECET in discriminatory fashion; either the ECET is applied to everyone or no one. My prediction: I believe a single-digit percentage of employers will actually move forward with this. Perhaps I'm wrong and the ECET sees wider adoption, but I'm not sure employers will bite.

Possibility: Replace Some or All State Income Tax with an Unincorporated Business Tax (UBT)

Another idea not yet adopted but floated as a possibility is the notion of helping self-employed taxpayers by swapping state income tax with a UBT, which bears similarities to the ECET strategy discussed above. Since UBT wouldn't fall under the purview of the SALT deduction limits, the theory goes that taxpayers would benefit by increasing the amount of taxes payable to New York State that do receive the federal government's blessing for an uncapped deduction. My take here isn't very different than my take on the ECET: while the federal government would have an uphill battle when fighting the validity of the deduction, practical barriers would limit how many taxpayers actually get to take advantage of the change.

This idea brings up a discussion that also applies to the ECET: for taxpayers residing in a state other than New York, the states of residence would need to reciprocate treatment -- otherwise, the savings at the New York level would simply translate to higher reported income in New Jersey, Connecticut, Pennsylvania, or Massachusetts. Would the states bother coordinating, or would they simply let the chips fall where they may? Time will tell.

Conclusion: Tread Carefully... and Consider Moving

In addition to the measures described above, New York also passed rules "decoupling" the state's tax treatment of certain items from that of the federal government. For instance, a taxpayer taking the standard deduction on the federal return can now itemize on a New York State return. Whereas the federal government nixed the deduction for alimony paid to an ex-spouse, New York kept the deduction at the local level. These differences will create a real headache for tax preparers, but they figure to give taxpayers some much-needed relief when cutting checks to the government next year.

It's always telling to examine what ultra-high-net-worth taxpayers, who typically have access to the highest echelon of tax advisors, are doing in response to a new tax law. If you believe the various news reports, many financial industry professionals are headed for low-tax jurisdictions, which probably means their accountants and lawyers concluded that they wouldn't get the benefit of these workarounds when the dust settles.

I wouldn't be surprised if the exodus out of high-tax jurisdictions picks up after the filing season for 2018 tax returns, when taxpayers realize two things: first, how much impact the new tax law will actually have; and second, the extent of the differential between their tax bill as a New York resident and their tax bill as a Florida resident. After the TCJA, the tax advantage of living in a state like Nevada or Texas is bigger than it's ever been. While I never advise a client to let taxes control her life, if you're an individual who always thought about moving out of a high-tax state in favor of a low-tax state, now appears to be the ideal time.

Curiously, I wonder whether the GOP considered the political effects of levying higher state taxes on coastal states and Illinois. Perhaps I'm off-base here, but according to my calculations, relocating New York voters to Florida and the Carolinas, or relocating California voters to Nevada, or relocating Illinois voters to Indiana doesn't exactly bode well for the Republicans' fortunes in federal elections, but I guess we'll have to see how the long-term effects of the tax law shake out.

Finally, the SALT deduction limitation has a December 31, 2025 "sunset," just like the other non-corporate changes in the TCJA. There's always the possibility that after the fight between the states and the federal government over workarounds reaches a conclusion, the SALT deduction may revert to its old uncapped ways -- but the state measures to circumvent the previous limits might still remain. This is a great illustration of why we tax professionals refer to the TCJA and other bills like it as "full employment acts:" because the fun will simply never end.

The foregoing may be considered attorney advertising under the New York State Rules of Professional Conduct.


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