With the 2017 Tax Cuts and Jobs Act (“Tax Reform”) fully enacted, taxpayers and practitioners are racing to find last-minute planning opportunities prior to the new year, and states are looking for ways to assist their residents prospectively. The most talked about planning opportunity, currently, is prepaying property taxes for 2018 to create a 2017 tax benefit around Section 11042(a)(6), which limits the state and local tax deduction to $10,000 beginning in 2018. However, imprecise wording contained within Section 11042(a)(6) could feasibly be interpreted to permit a deduction for state and local income taxes as well – depending on how you read the provision.
Separately, high-tax states whose residents may be more severely impacted by the limited state and local tax (“SALT”) deduction than residents of lower-taxed jurisdictions, are also considering potential workarounds to the SALT deduction limitation separate and apart from the one-time SALT prepayment benefit. Our below post touches upon each of these items, with additional proposals and planning opportunities likely to appear as both taxpayers and states have time to digest the enacted Tax Reform.
Prepayment of State and Local Taxes
As mentioned above, many taxpayers are seeking a one-time benefit by prepaying 2018 state and local taxes by December 31, 2017, and obtaining a deduction on their 2017 return for such payments. For tax periods beginning after December 31, 2017, Section 11042(a)(6) of the Tax Reform prohibits taxpayers from deducting more than $10,000 in state and local taxes. The introductory language to Section 11042(a)(6) specifically states “Limitation on Individual Deductions for Taxable Years 2018 Through 2025. — In the case of an individual and a taxable year beginning after December 31, 2017, and before January 1, 2026.” In addition to limiting the SALT deduction to $10,000, the relevant language specifically states “…an amount paid in a taxable year beginning before January 1, 2018, with respect to a State or local income tax imposed for a taxable year beginning after December 31, 2017, shall be treated as paid on the last day of the table year for which such tax is so imposed.” The effective date for this provision is for “taxable years beginning after December 31, 2016.”
Based on the plain language of Section 11042(a)(6), it seems clear that prepaid property taxes may be deducted so long as the other requisite requirements for such a deduction are satisfied. However, when reviewing the introductory language (i.e., addressing periods “beginning after December 31, 2017) in conjunction with the legislation’s proposed limitation of prepaying income taxes, it appears that there is an argument that such limitation is only applicable for periods beginning after December 31, 2017 because the provision only applies to such periods. While the IRS may push back on such a position, taxpayers could potentially rely on such language as a basis to do so and should consider the implications if unsuccessful (e.g., audit, interest-free loan to the government, etc.).
If a taxpayer is interested in prepaying property or income tax, they should consult with their tax adviser to confirm whether the relevant jurisdictions permit the prepayment of such taxes. The IRS recently issued a news release on their website warning taxpayers that “whether a taxpayer is allowed a deduction for the prepayment of state or local real property taxes in 2017 depends on whether the taxpayer makes the payment in 2017 and the real property taxes are assessed prior to 2018. A prepayment of anticipated real property taxes that have not been assessed prior to 2018 are not deductible in 2017.” Additionally, some states have already addressed whether they can or will permit prepayment of property taxes. For example, New York’s Governor Cuomo signed an executive order on December 22, 2017 permitting localities to accept payments on 2018 property taxes, although the executive order does not mandate the locality to do so.
Finally, it is worth addressing that the prepayment of state and local taxes may have limited to no benefit for taxpayers subject to the Alternative Minimum Tax (“AMT”). Specifically, a SALT deduction may have little to no economic benefit if the taxpayer is subject to the AMT because such deduction is added back in the AMT computation. Accordingly, this is one more reason to consult with a trusted advisor if considering whether to make a prepayment of taxes.
States Considering Legislative Proposals
In addition to the one-time benefit afforded to taxpayers by prepaying state and local taxes to offset the impact of the limited SALT deduction, states are considering legislative proposals to combat the impact of the limited SALT deduction. We address recent proposals in New York with two separate “Hold Harmless” bills that seek to offset the impact of the Tax Reform. Additionally, we discuss the potential for states to effectively reclassify personal income taxes as charitable contributions to the state and the potential for a state to replace its personal income tax with an employment tax.
New York’s Hold Harmless Proposals
New York is exploring at least two separate “Hold Harmless” proposals. The first, set forth in New York Senate Bill S6974, amends Tax Law section 607 to provide for New Yorkers to calculate their New York personal income tax liability based on the Internal Revenue Code in effect prior to the Tax Reform. The justification for the bill is to provide New Yorkers with deductions that were removed in the recent Tax Reform and to provide assurance to New Yorkers that their “New York State personal income tax calculations will not fluctuate based on changes to the federal law.” It is unclear of the financial impact that this bill will have in New York.
The second “Hold Harmless” proposal is set forth in New York Senate Bill S6951 and is known as the “Hold Harmless Tax Credit.” This proposal amends Tax Law section 606 to provide a state income tax credit equal to any increase in a New York resident’s federal tax liability due to changes in the Tax Reform. The financial impact of this proposal is also unclear, but it appears that New York would be funding at least a portion of their residents’ federal tax increases. Moreover, this proposal appears to require New York residents to calculate their tax liability under both pre- and post- Tax Reform to determine whether the credit applies to them.
Charitable Contributions in Lieu of State Income Tax
States could potentially circumvent the impact of the SALT deduction limit by allowing residents to make charitable gifts to the state, effectively in lieu of paying state personal income taxes. In exchange for the charitable donation to the state, “generous donors” could, in turn, receive a state income tax credit for the entire amount of their charitable gift to offset all or a portion of their state income tax due. Under current federal law, the amount of the charitable donation would likely permit a deduction on the taxpayer’s personal income tax return.
Replacing Income Tax with Employment Taxes
In addition, or in combination with the above charitable contribution opportunity, states could also try to replace the state income tax with payroll taxes imposed on the employer. The employer can then lower the salaries it pays out to its employees by the same amount paid in income tax and workers would not need to deduct anything, but would wind up earning the equivalent to what they would have earned had a full state income tax deduction been permitted. There are several complications with this approach, such as modifying existing employment contracts, drafting legislation to effectively repeal some or all of the state personal income tax provisions, and reviewing how non-wage earners would be affected by such a provision. Nonetheless, this proposal appears to be one potential option to assist taxpayers in high tax states.
As only a few days are left before the new year, taxpayers will need to act quickly and decisively if they plan to prepay any of their SALT obligations. Additionally, we recommend continuing to watch for state proposals to work their way through the legislative process. If states do enact potential workarounds from the SALT deduction limit, we should expect Congress and/or the IRS to push back on such proposals given the potential for a significant fiscal impact.