Lawsuits, New Charities? States Eye Ways Around Federal Tax Law

Daily Tax Report: State provides authoritative coverage of state and local tax developments across the 50 U.S. states and the District of Columbia, tracking legislative and regulatory updates,...

By Che Odom

Several states are already pushing plans to mitigate the negative impact taxpayers may feel from the federal tax law’s new limit on the deductibility of state and local taxes on federal returns.

New York Gov. Andrew Cuomo (D) is the only one so far who has publicly promised to sue the federal government over the new cap, questioning its constitutionality.

Other state officials from high-tax states—such as New York, New Jersey, California (see related story, this issue), Connecticut, and Illinois (see related story, this issue), as well as Washington, D.C.—have announced their intent to eye potential end-runs of the limit, such as encouraging new charitable contributions, or replacing some taxes on individuals with payroll taxes paid by employers—both of which are federally deductible.

California introduced a bill Jan. 4 to do the former: S.B. 227, from Senate President Pro Tempore Kevin de Leon (D) and two other senators, would allow taxpayers to receive a credit for amounts they donate to the California Excellence Fund.

Governors, especially those from blue states, tried in vain to convince Congress to spare the full deduction.

The 2017 tax act ( Pub. L. No. 115-97), signed by President Donald Trump on Dec. 22, allows taxpayers who itemize to deduct their state sales, individual income, and property taxes up to $10,000 beginning this year. The deduction previously was unlimited.

California, New York, Illinois

Many governors who battled for a no-limit deduction, such as California Gov. Jerry Brown (D) and Colorado Gov. John W. Hickenlooper (D), haven’t yet said what measures they may take to lessen the impact of the limit.

Taxpayers in California would use the credit for a donation to the California Excellence Fund to offset federal tax liabilities. They could carry forward credit amounts that exceed their personal income tax liabilities for five years. According to de Leon, 6 million California taxpayers itemize deductions and claim an average of $22,000 for state and local taxes.

In New York, Cuomo said Jan. 3 that he also is looking at “a major shift” in the state’s tax law to reduce its reliance on the personal income tax. Options being considered include creating a statewide payroll tax system, creating new charitable organizations, and eliminating the carried interest tax break used by private equity. The Democratic speaker of the New York Assembly and the Republican majority leader of the state Senate have also indicated support for mitigating the impact of the federal tax bill, but neither has announced any specific plans.

Illinois Gov. Bruce Rauner (R) said in a series of Twitter posts and a talk-radio interview Jan. 3 that he would devote much of the final year of his term to restructuring state and local tax systems that hamper economic growth. Rauner characterized Illinois as a high-tax state that must enact significant reforms to reap the rewards envisioned under the new federal tax law.

Rauner emphasized that the new $10,000 cap on deductions for state and local taxes would be “punishing” for Illinois taxpayers, adding urgency to his demands for reform.

During the radio interview, Rauner pointed to two major priorities during the upcoming legislative session designed to “end run” the impacts of the federal tax code changes.

Rauner said he hopes to roll back the $5 billion income tax increase championed by House Speaker Michael Madigan (D) last summer under S.B. 9. The measure, passed despite Rauner’s veto, boosted the corporate income tax rate to 7 percent from 5.25 percent, generating about $500 million annually. In addition, the personal income tax rate was bumped to 4.95 percent from 3.75 percent, generating almost $4.5 billion annually.

Rauner also said he would seek legislation freezing local property taxes and empowering units of government to shave down rates through local referendums.

Mum for Now

States are still picking apart the new federal tax law to determine any negative impacts it may have on revenue.

Officials from Maryland, Vermont, Michigan, Montana, Utah, Colorado, and Nebraska told Bloomberg Tax they hope to finish their analysis in the coming weeks. The Michigan treasurer said this week that the federal tax law will increase Michigan personal income tax revenue by more than $1 billion.

A spokesperson for North Dakota’s revenue department said the state’s analysis suggests a negligible impact on state revenue, so its lawmakers aren’t likely to meet in a special session to address the deduction. North Dakota’s legislature meets every two years, with its next session in 2019.

‘Devastating’ Bill

New Jersey Gov.-elect Phil Murphy’s (D) spokesman, Dan Bryan, told Bloomberg Tax that the new governor will “explore every option to combat this devastating tax bill,” but wouldn’t go as far as to say the state might sue the federal government. On Dec. 20, however, Murphy told CNBC that he would consider litigation over the deduction limit.

Cuomo said Jan. 3 that the law’s limitation on the state and local tax deduction violates the equal protection and state’s rights provisions of the Constitution. Several leading tax attorneys have told Bloomberg Tax that neither the U.S. Constitution nor Supreme Court case law prevents Congress from acting as it did to limit the deduction.

New Jersey’s Republican Senate Whip Joseph Pennacchio has said he may introduce a bill this legislative session that asks Congress to reconsider the deduction limit.

In Nebraska, state Sen. Jim Smith (R) told Bloomberg Tax that he is very concerned with “making taxpayer whole,” but declined to offer specifics in advance of next week’s State of the State address, to be delivered by Gov. Pete Ricketts (R).

Payroll-Tax Option

Kevin Sullivan, commissioner of the Connecticut Department of Revenue Services, told Bloomberg Tax that his office is considering a plan to replace the state income tax with payroll taxes paid by employers, as a way to skirt the reduced SALT deduction. It’s similar to Cuomo’s plan in New York and one that has support in New Jersey, among other states.

Illinois, another state with a relatively high tax rate, doesn’t have a payroll tax. Carol Portman, president of the Taxpayers’ Federation of Illinois, told Bloomberg Tax that she doesn’t think it will be possible to get state lawmakers to adopt one.

“We don’t have a payroll tax in place, so that option would require creating a brand new tax system, and I cannot imagine there are enough legislators with the stomach for that,” Portman said. “If it was accompanied by a decrease in the income tax rates, that’d be helpful, but I still don’t see it.”

Charitable Donations

Cuomo’s plan in New York, like one being floated in California and other states, would encourage tax-deductible contributions to charities that would support public services as a workaround of the deduction limit, Cuomo said during a State of the State address Jan. 3.

Charitable groups established by the state could, in essence, accept donations, replacing tax payments. Charitable contributions would be deductible on federal returns.

Manoj Viswanathan, an associate professor at University of California Hastings College of the Law, told Bloomberg Tax that taxpayers in high-tax states could take advantage of such state-level initiatives.

However, even if a state allowed taxes to be characterized as charitable contributions, that wouldn’t make them so for federal tax purposes. IRS Publication 526 says that taxpayers can’t deduct as a charitable contribution any payment for which they receive a benefit in return.

With assistance from Tripp Baltz, Michael J. Bologna, Christopher Brown, Alexander Ebert, Laura Mahoney, Aaron Nicodemus, Leslie A. Pappas, Gerald B. Silverman, and Paul Stinson

To contact the reporter on this story: Che Odom at codom@bloombergtax.com

To contact the editor responsible for this story: Ryan C. Tuck at rtuck@bloombergtax.com

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