Tax Reform Friday: High Income Tax States Strike Back Against Limitation of State Tax Deduction


Gov. Cuomo

Earlier today, President Trump signed a two-year budget deal to end the second federal government shutdown of the year. Objecting to increased deficits, Sen. Rand Paul (R-Ky.) held up a vote on the bill late into the night. While that drama may be over, high income tax states have just begun to grapple with how to keep their lights on and blunt the blow of tax reform’s $10,000 limit on state tax deductions. Below is this week’s roundup of some of the latest proposed state income tax changes that attempt to do so. 

California

This democratic stronghold imposes the highest individual income tax of any state in the nation, with a top rate of 13.3 percent. It should come as no surprise then that the Golden State is at the forefront of efforts to circumvent the state tax deduction limit. Under a bill recently passed by the California Senate, the state would grant taxpayers a credit against their individual income tax liability equal to 85 percent of the amount they contribute to the newly created California Excellence Fund.

The idea here is that taxpayers will then be able to fully deduct these contributions under the still intact federal charitable deduction. As originally introduced, the bill provided a 100 percent credit for contributions to the state’s general fund. Perhaps believing that this would be too easily challenged, the Senate reduced the credit amount to 85 percent. If passed, related deductions will no doubt still be subject to IRS scrutiny.

Illinois

Earlier this week, the Illinois House followed California’s lead by introducing a bill that would create the Illinois Excellence Fund and permit an income tax credit equal to 100 percent of the amount contributed to the fund. There is no indication yet whether Illinois legislatures think that reducing the credit amount would make this method more credible. Ultimately, it may be up to some brave high-income earners to test the theory.

Connecticut

In the land of steady habits, Gov. Dannel P. Malloy (D) has proposed two “workarounds” of the elimination of the state and local tax deduction in his 2019 fiscal year budget proposal, according to Aaron Nicodemus in the Daily Tax Report: State (subscription required).

Specifically, the first workaround involves a new tax on pass-through entities that will be fully offset by a personal income tax credit. The second workaround would allow municipalities to create charitable organizations that support town services, in conjunction with a local property tax credit to avoid the $10,000 cap on the state and local tax deduction.

Additionally, the state is joining a multi-state coalition, along with New Jersey and New York, which plans to sue the federal government to challenge the elimination of the full state and local tax deduction.

New York

In the Empire State, lawmakers have proposed ideas both to prevent the state from receiving a large revenue increase from the federal tax reform law and to protect individuals who would be restricted by the $10,000 cap on the state and local tax deduction.

As an attempt to avoid a large “windfall” of revenue to the state, Gov. Andrew M. Cuomo (D) has proposed “eliminating a requirement that state taxpayers must take the state standard deduction—and not itemize—if they take the standard deduction on their federal income tax returns,” as reported by Gerald B. Silverman in the Daily Tax Report: State (subscription required). Additionally, New York lawmakers are considering “creating a credit equal to any increase in individual tax liability resulting from the federal changes…and possibly replacing some income taxes for wage earners with a payroll tax on employers[,]” according to Bloomberg Tax’s Che Odom.

Finally, as mentioned above, New York is one of three states preparing to sue over the SALT deduction.

What is your favorite state response to tax reform? Continue the discussion on Bloomberg Tax’s State Tax Group on LinkedIn.

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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