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Status of the SALT Deduction

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Under the Tax Cuts and Jobs Act, signed into law by President Donald Trump on December 22, 2017, the itemized deduction for state and local taxes (“SALT”) has been modified for tax years after 2017. Taxpayers in high tax states, such as New Jersey, are the most dramatically affected. Those states are challenging the new SALT limitation and developing workarounds. One approach would allow taxpayers a tax credit against their property tax bill for a donation to a state sponsored charitable fund. Taxpayers would claim a deduction for the charitable contribution on their federal tax returns. It remains to be seen whether any of the workarounds being considered will be successfully implemented and, if so, whether they will withstand IRS scrutiny.

Under prior law, individual taxpayers were allowed an unlimited itemized deduction for state and local real property taxes, state and local personal property taxes, and state and local income taxes paid or accrued in the taxable year, whether or not incurred in a taxpayer’s trade or business (or, in lieu of the deduction for state and local income taxes, taxpayers could elect an itemized deduction for state and local general sales taxes).[1]

Under the Tax Cuts and Jobs Act, the SALT deduction has been modified. For tax years beginning after December 31, 2017 and before January 1, 2026, the aggregate deduction for state and local real property taxes, state and local personal property taxes, state and local income taxes, and state and local general sales taxes (if elected) for any tax year is limited to $10,000 ($5,000 for married individuals filing separately).[2] With the exception of state and local income taxes, this limitation does not apply if the taxes are paid or accrued in carrying on a trade or business.[3]

The seven states most affected by the cap on SALT deductions are California, Connecticut, Washington DC, Maryland, Massachusetts, New Jersey, and New York.[4] Many of those states are challenging the new SALT limitation and proposing bills to help taxpayers work around the limitation.  U.S. Representative Josh Gottheimer, D-N.J., has also already introduced a bill that would repeal the federal SALT deduction limitation.[5]

For example, New York, New Jersey, and Connecticut have organized a multi-state coalition to challenge the constitutionality of the new cap on the SALT deduction in court. Maryland may also soon be joining the coalition. New York Governor Andrew Cuomo stated: “not only do we find it philosophically repugnant and practically damaging, but legally, we believe there is a very strong argument that it’s unconstitutional.” Governor Cuomo claims that the SALT deduction cap is unconstitutional because it violates states’ rights and constitutes double taxation. New Jersey Governor Phil Murphy further stated: “It’s clear it’s politically motivated [and that] it’s punishment of blue states like New Jersey, New York, and Connecticut, and others who already pay far more into the federal government than we receive.” The governors have stated that the lawsuit could be filed in federal court within the next few weeks.

As a workaround to the SALT limitation, the New Jersey Senate recently approved legislation that would allow municipalities to set up charitable funds for specific purposes, such as police or schools, and allow taxpayers to substitute donations made to such funds for property tax payments.[6] Taxpayers could make donations to the charitable fund and receive a 90% tax credit against their property tax bill. Taxpayers could then claim the donation as a charitable contribution and receive a deduction on their federal tax returns. Unlike the SALT deduction, the charitable contribution deduction is not subject to a cap.[7] If the tax credit exceeds the net property taxes owed, the fund would roll the credits forward for up to five years. Similarly, Representative Peter Breen of Illinois introduced a bill that would allow Illinois residents to donate money to 501(c)(3) foundations supporting public K-12 schools, such donations would be fully tax deductible and would provide state income and property tax credits equal to 100% of the donation.[8]

In California, Senate President pro Tempore Kevin de León introduced legislation to create a charitable tax credit against the state’s income tax in return for donations to a “California Excellence Fund.”[9] Likewise, a Washington state bill would create a state sales and use tax exemption in return for contributions to the state by taxpayers.[10] The bill would create a “Washington excellence fund” to which taxpayers could donate and receive in return a retail sales tax exemption equal to the donation amount. The exemption would expire after five years. The bill would thus allow the state to receive donations in lieu of sales tax payments, which would then allow taxpayers to claim the federal charitable deduction on their federal taxes rather than the SALT deduction.

However, there are uncertainties as to whether the state charitable fund-approach would actually withstand IRS scrutiny, since generally charitable contributions must be made without an expectation of receiving anything in return in order to be eligible for the federal charitable deduction.[11] For example, the U.S. Supreme Court has stated: “A payment of money generally cannot constitute a charitable contribution if the contributor expects a substantial benefit in return.”[12]

In a Tax Foundation study, the Tax Foundation noted that “[c]ase law and IRS regulations generally require charitable intent for a contribution to be deductible, meaning that the individual does not receive a substantial benefit from the contribution. Against this requirement, the sole purpose of the proposed contributions in lieu of taxes proposal is financial gain.” The Tax Foundation ultimately concluded that, while the states’ proposals are interesting, they are unlikely to succeed. The Tax Foundation instead suggests that “if states are genuinely concerned about the effects of their tax codes absent an uncapped state and local tax deduction, they should consider revisiting their tax rates rather than devising increasingly convoluted and legally suspect workarounds.”[13]

Moreover, Treasury Secretary Steven Mnuchin has stated that he thinks “it’s one of the more ridiculous comments to think that you can take a real estate tax that you’re required to make and dress that up as a charitable contribution.” In response to Secretary Mnuchin’s comments, Congressman Gottheimer wrote a letter to the Secretary in which the Congressman notes that a paper authored by some of the most prominent tax law professors in the country finds the plan consistent “with a correct and long-standing tran-substantive principle of federal tax law” and that the rule “is supported not only by decades of precedent but by a host of policy considerations.”[14]

Some states have come up with workarounds that do not involve charitable contribution deductions. In New York, Governor Cuomo is considering creating a new employer-side payroll tax with a credit against state income tax liability for employees, since employer-side payroll taxes are deductible, while individual state income taxes are subject to the SALT cap. Connecticut Governor Dan Malloy is proposing a workaround to the SALT limitation which utilizes the fact that SALT deductions are still fully available to businesses.[15] Under the proposal, Connecticut would tax passthrough businesses at the entity level and create an offsetting individual state income tax credit for the entity’s members. The proposal would impose a 6.99% income tax on the net receipts of partnerships, S corporations, and limited liability companies that are taxed as partnership for federal purposes. Passthroughs could then claim the amount as an expense for deduction purposes. The individual income tax credit would offset 100% of the additional tax paid by the entity.

Thus, while many states have developed plans to work around the SALT limitation imposed under the Tax Cuts and Jobs Act, it is still unclear whether any of these approaches will be successfully adopted in any state and, if so, whether the IRS will approve (or at least, not disapprove) of any of the approaches.

[1] I.R.C. § 164(a), (b)(5).

[2] I.R.C. § 164(b)(6); 2017 Tax Cuts and Jobs Act § 11042(a).

[3] Id.

[4] Wamhoff, Repealing, or Working Around, the Cap on State and Local Tax Deductions Would Make the Trump-GOP Tax Law Even More Unfair (Jan. 17, 2018).

[5] H.R. 4789.

[6] S. 1893.

[7] I.R.C. § 170.

[8] H.B. 4563.

[9] S.B. 227.

[10] H.B. 2853.

[11] See I.R.C. § 170(a)(1).

[12] U.S. v. American Bar Endowment, 477 U.S. 105, 116 (1986).

[13] Tax Foundation, State Strategies to Preserve SALT Deductions for High-Income Taxpayers: Will They Work? (Jan. 2018), available at https://taxfoundation.org/state-strategies-preserve-state-and-local-tax-deduction/.

[14] Letter from Congressman Josh Gottheimer to Secretary Steven Mnuchin (Jan. 12, 2018).

[15] S.B. 11.

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