Individual Income Insights: The Wait is Over: New York Enacts Federal Deduction Limitation Workarounds


 

New York Skyline

In the early hours of March 31, New York legislators passed the state’s 2018–2019 budget bill S.7509 / A. 9509 and sent it to the governor’s desk for approval. The bill contains sweeping legislation that effects the taxation of almost every resident in the state. Though many people will focus on the new “Women’s Agenda” or increased education and infrastructure spending, most tax practitioners will focus on understanding how these major tax changes affect their clients. Uniquely, the bill changes not only New York state and local taxes, but also attempts to lower residents’ federal tax liability through charitable deductions and a new payroll tax, each of which are meant to recover part or all of the deduction lost through the cap on the federal deduction for state and local taxes. While creative, only time will tell whether the federal government accepts New York's attempt to protect residents from significant federal tax increases. 

There Are No Truly Selfless Acts

New York is the first to enact what states have been discussing for months: a new charitable contribution scheme to reduce a resident’s tax liability. The bill establishes a charitable gifts trust fund, in which two separate account are established: the “Health Charitable Account” and the “Elementary and Secondary Education Charitable Account.” Under the new law, a contribution qualifies for a state personal income tax credit equal to 85 percent of the sum of all contributions made in the taxable year to the charitable gifts trust fund, Health Research, Inc., and the State University of New York Impact Foundation or the Research Foundation of the City University of New York. 

The new section’s intent is to transform transfers which under the old law would be state income tax payments (for which the federal deduction is currently capped at $10,000 for state income, property, and sales and use tax payments) into charitable contributions, the deduction for which was recently expanded by the 2017 federal tax act (Pub. L. No. 115-97). 

However, numerous practitioners across the country have raised doubts about the plan’s feasibility. Tax attorneys and CPAs at the March 2018 ABA State and Local Tax Conference were keen to ask how a payment to a trust to reduce one’s tax liability is charitable, because the individual making the payment receives, in exchange, a tax benefit, and cannot claim to have charitable intent. In the case that a taxpayer receives a benefit from charitable contributions, the taxpayer may only deduct the portion of the contribution which exceeds the fair market value of the benefit, wiping out virtually all of the deduction’s value for federal purposes. Many practitioners speaking at the conference were doubtful that the IRS will go along with the plan willingly, and predicted litigation, and perhaps even legislation, is almost certainly in the offing. 

I Work Hard for the Money

While attempting to implement a new charitable contribution regime, New York legislators have also introduced a new optional payroll tax. Employers may elect to opt in to the program at the beginning of each tax year. The system charges employers a payroll tax on employee wages, which is deductible federally, and then offers a corresponding personal income tax credit for employees whose wages would hypothetically decrease because of the employer’s additional expense. 

On paper, the plan seems to work: the state taxes the payroll expense instead of wages received, and any drop in wages due to the tax is offset by a complete state income tax credit. Several challenges exist, however, if a state has a graduated income tax rate (like New York), or for those employees with two income streams. After clearing significant administrative hurdles, New York then would have to convince the IRS that the plan is workable. Though a payroll tax is a perfectly legal way for states to raise revenue, granting an income tax credit may be characterized as income taxes paid by an employer, potentially increasing a resident’s tax liability, according to the Tax Foundation’s Jared Walczak. As with the charitable deduction scheme, the long-term viability of these plans depends on how the IRS will respond. 

Practitioners across the state will need to plan for greater uncertainty as states increase their efforts to offset negative impacts of the 2017 federal tax act. While New York has taken the lead in this area, taxpayers and tax practitioners should expect states like New Jersey, California, and Connecticut to quickly follow suit. 

Continue the discussion on Bloomberg BNA’s State Tax Group on LinkedIn: Are there possible workarounds that you would like to see enacted? 

For more information on the impact of Pub. L. No. 115-97, examine Bloomberg Tax’s Tax Reform Roadmap, showing detailed comparisons between pre-reform law and impending changes, with pertinent cites attached.

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