State Tax Deduction Workarounds Likely to Hit Snags

Taxpayers who pay more than $10,000 in state and local taxes, the new limit on that federal deduction, should not count on relief any time soon. Even if their state approves a workaround for the so-called SALT deduction limits that were enacted by new federal tax legislation, there are questions about implementation.

Jared Walczak, a senior policy analyst at the conservative Tax Foundation, warns that “these avoidance schemes” may increase an individual’s total tax liability and could be subject to an audit.

Howard Gleckman, a senior fellow at the the Urban-Brookings Tax Policy Center, doesn’t expect many taxpayers will take advantage of these workarounds until the IRS clarifies that they’re legal.

In addition, says Gleckman, many taxpayers will choose to take the standard deduction, which doubled under the new tax legislation, rather than itemize deductions and therefore won’t need a workaround.

To date only New York state has signed legislation to help offset the new SALT deduction limits. The New Jersey Legislature passed a similar type of bill, but the governor is asking for a slight adjustment before signing it, and in California only one branch of the State Legislature has passed an offset bill.

The New York law includes a series of reforms to the state tax code that capitalize on the facts that charitable contributions from individuals and payroll taxes paid by employers are both fully deductible from federal taxes. Participation in the plan by employers and local governments as well as taxpayers would be voluntary.

The plan has several parts:

• An optional state payroll tax, called an “employer compensation expense tax,” which would assess employers 5% on payrolls over $40,000, phased in over three years, and provide workers of those employees a tax credit equivalent to the value of the ECEP.
• Two state-run charitable funds — for health care and education. Taxpayers could donate to both and receive tax credits in return equal to 85% of their donation.
• Optional charitable funds created by local governments to fund schools and other local programs. Taxpayers would make donations and receive tax credits in return, which would be decided by the local governments.
• Delinking of state tax code from the federal tax code so that taxpayers paying more in federal taxes won’t also be paying more for state taxes. In addition, taxpayers would be able to itemize on state tax returns even if they didn’t on federal tax returns.

Walczak of the Tax Foundation says the IRS likely won’t go along with the New York state plan for several reasons, including the fact that the charitable deductions aren’t really that.

Gleckman agrees that it could be difficult for such charitable donations to qualify as federal tax deductions because the taxpayer would be paying them in lieu of a tax, which means it isn’t strictly voluntary as charitable contributions traditionally are.

The payroll tax part of the plan presents other complications. It could pass legal muster, but employers would want to reduce employee compensation by the amount of the additional payroll tax they would pay, which is not easy to do in practice or to explain to the employees who wouldn’t actually lose compensation.

“Employers can’t just slash salaries willy-nilly, even if there’s a good argument for it being to the employees’ benefit,” writes Walczak.

“The details really matter” about this part of the plan, says Gleckman. He adds that it also poses challenges for New York state employers who employ out-of-state workers, since those workers couldn’t receive a New York State tax credit.

— Related on ThinkAdvisor:

• Life Insurance Planning Hit by New Tax Rules
• Investing in 529, ABLE Plans/? Better Check Tax Law Changes
• 10 States Whose Residents Pay the Most Federal Taxes