While several high-tax states have entertained ideas to work around the new limitation to the state and local tax deduction, New York, New Jersey, and Connecticut have become the first states to actually enact legislation.
The enactment of the Tax Cuts and Jobs Act (TCJA) on December 22, 2017, saw a significant limitation placed on the state and local tax (SALT) deduction. Under the old law, the deduction allowed those who itemize on their returns to commingle their state and local taxes and deduct the sum in full. The new law places a $10,000 ceiling on that deduction, much to the chagrin of high-tax states like New York, California, and New Jersey. Residents of these states typically have SALT deductions higher than the new limit.
Soon after the enactment of the TCJA, there were whispers among some high-tax states to engineer a plan so residents could claim a credit toward their state income tax liability for contributions made to certain state and municipal charities. The intended effect would reduce a resident’s state income tax liability and create a federal charitable contribution deduction, while at the same time not negatively impacting state revenue.
On March 30, 2018, New York’s legislature approved a budget that includes a response to the TCJA’s SALT deduction limitation. The legislature approved two measures as part of its fiscal year 2019 budget and in direct reply to federal tax reform. The first is an elective payroll tax for employers and the second includes the creation of a charitable gifts trust fund. Both measures would effectively allow New York residents to reduce their tax bills in accordance with the new SALT deduction limitation.
Optional Payroll Expense Tax
The optional payroll expense tax is paid by employers on employee wages in excess of $40,000. The tax rate is 1.5% for 2019 and will gradually increase to a 5% maximum in 2021. “Payroll expense” refers to salaries and wages as we typically know them and the employer expense would translate into a personal income tax credit for employees. The credit for employees is an interesting proposal. However, it is currently unclear if the payroll expense has any substantive benefit to the employer.
State Charitable Contribution Trust Fund
The budget also approved the creation of a New York State charitable contribution trust fund comprised of two separate accounts:
- A health charitable account, and
- An elementary and secondary education charitable account.
The benefit to taxpayers is simple. Starting in 2019, residents can utilize a credit against their state income tax liability equal to 85% of contributions made to either of the foregoing accounts. This means a $500 contribution toward New York’s elementary education translates into a $425 state income benefit to the payor, as well as charitable deduction. Essentially, the new structure shifts a resident’s payments to the state from a lost federal SALT deduction to an allowable federal charitable contribution deduction. In addition, the legislation authorizes local governments to offer property tax credits for similar fund contributions.
New York is not alone in this arrangement. New Jersey has responded to the federal tax overhaul in a similar style. Governor Phil Murphy recently signed legislation that would license localities to create charitable funds in order to accept taxpayer donations. In return, taxpayers would be permitted a property tax credit equal to 90% of their contributions. The credit would take effect for the next property tax assessment following the acceptance of their donation by the state.
Pass-through Entity Tax
Connecticut’s pending legislation, S11, authorizes a similar credit for contributions made to newly-created municipal charities, the bill also enacts a new pass-through entity tax (PET). The new PET is imposed at a rate of 6.99% and subtracts from income for pass-through entities receiving a distributive share of income from another pass-through entity in a tiered structure. A pass-through entity subject to the new PET is required to report to each of its members their direct pro rata share of the PET tax imposed on the entity and the indirect pro rata share of the tax imposed on any lower-tier entity of which the business entity is a member.
A nonresident member of a pass-through entity subject to the PET is generally not required to file a Connecticut income tax return if the income from the pass-through entity is nonresident’s only Connecticut source income. For residents that are subject to the state’s personal income tax, the legislation creates a refundable credit equal to 93.01% the resident’s direct and indirect pro rata share of the tax paid by the pass-through entity. The new PET circumvents the TCJA’s $10,000 SALT deduction limitation because an entity level tax would be fully deductible at the federal level, unlike the personal income taxes passed through to a pass-through entity’s members or partners. New York is considering similar legislation that would impose an entity-level unincorporated business tax.
We will continue to monitor how the Internal Revenue Service responds as more states could follow with their own responses to the SALT deduction limitation. Some tax scholars have already argued that the states’ plans to work around federal law through the creation of state or municipal charities fail to create an allowable charitable contribution deduction.
If you have questions about the future deductibility of your state and local taxes, please contact our tax advisors or Michael L. Colavito, Jr. at 301.231.6200.