IRS Strikes Back Against States Trying to Avoid Limitation on State and Local Tax Deduction
Since the enactment of Trump’s Tax Cuts and Jobs Act (“TCJA”), state Democrat leaders have taken aim to counteract the impact of the federal bill through state legislation and other means. In a previous blog, we looked at some of the measures being proposed by Democrat leaders in New York and California, where the bill’s new limitation on the state and local tax (“SALT”) deduction will likely have a significant impact.
In a new Notice, the IRS has stated that it intends to propose regulations that are meant to curtail the workarounds adopted by several states to avoid the new SALT deduction limitation. In this blog, we describe the TCJA’s SALT deduction limitation, some of the state workarounds, and the regulatory principles that will be used by the IRS to reinforce the deduction limitation.
The New SALT Deduction Limitation
Under the newly-enacted Tax Cuts and Jobs Act (“TCJA”), starting with the 2018 tax year, state and local property and sales taxes are deductible only when paid (or accrued) in carrying out a trade or business, and state and local income taxes are not allowable as a deduction.
However, an individual taxpayer can claim an itemized deduction of up to $10,000 for state and local property taxes not paid (or accrued) in carrying on a trade or business, and state local income taxes paid (or accrued) during the tax year. Foreign real property taxes are no longer deductible.
States Punch Back
Several states have already implemented legislation designed to work around the SALT deduction limitation. New York, for instance, now offers “charitable gifts trust funds” to which taxpayers can make deductible contributions and claim a tax credit equal to 85% of the charitable donation.
New Jersey now offers a similar charitable deduction option, and California is currently working on the same type of workaround.
The Federal Counter Punch – Notice 2018-54
In Notice 2018-54, the Treasury Department and the IRS state they intend to propose regulations addressing the “federal income tax treatment of transfers to funds controlled by state and local governments (or other state-specified transferees) that the transferor can treat in whole or in part as satisfying state and local tax obligations.” The proposed regulations will “make clear that the requirements of the Internal Revenue Code, informed by substance over-form principles, govern the federal income tax treatment of such transfers,” and will “assist taxpayers in understanding the relationship between the federal charitable contribution deduction and the new statutory limitation on the deduction for state and local tax payments.”
In implementing the proposed regulations, Treasury Department and the IRS warn taxpayers to be mindful that federal law, and not state and local law, controls the proper characterization of payments for federal income tax purposes.
For the time being, the Notice seems focused on the charitable deduction workaround, but the intended broad use of substance over form principles shows that the IRS is prepared to curtail any additional workarounds that states might try to implement in the future.
The Final Scorecard For U.S. Expats
In truth, most U.S. expats will most likely not be affected by the SALT deduction limitation, because they are no longer domiciled in a U.S. state. However, some expats may potentially be affected – such as U.S. citizens who have recently moved abroad and are still considered temporarily domiciled in a state, or U.S. citizens living abroad who still have business concerns in the U.S.
In the bigger picture, since the Tax Cuts and Jobs Act is still relatively new, it may take some time to fully understand its impact on taxpayers. Our blog page will continue to monitor events related to the TCJA and its impact on expats moving forward.
By Ephraim Moss, Esq. & Joshua Ashman, CPA