- Move to a low tax state. Taxpayers have done this for decades and with the greater pain, the Act has created for paying high state taxes. The problem with this solution for many is that those most affected are doctors, lawyers, accountants, brokers, etc. who do not qualify for the pass-through entity 20% deduction and lose large state tax deductions. Licensed professionals can’t readily move.
- Create at least one non-grantor trust, perhaps more (but there are proposed Regs out on this too!) and shift your residence and property tax payments to a trust that gets its own $10,000 SALT limit.
- Create non-grantor trusts in no-tax states and shift your non-pension portfolio assets out of your high tax state and avoid, at least defer state income taxes.
Four Workarounds to SALT Deduction Limits in Light of IRS Proposed Regulations
Martin Shenkman Contributor Forbes.com
IRS regulation restricts contributions in lieu of state tax payment to avoid SALT restrictions, but options remain
daring taxpayers living in high tax states that have a charitable credit program might opt to make donations and claim their tax credits now
Proposed Regulations Just Issued to the Limit States Circumventing the New Tax Laws
The Tax Cut and Jobs Act of 2017 (“Act”) dramatically changed many aspects of the tax system. One of the most talked about changes is the imposition of severe limitations on deducting state and local taxes (“SALT”) which are now capped at $10,000. The IRS regulation restricts contributions in lieu of state tax payment to avoid SALT restrictions but options remain High tax states most affected have tried several tactics to help circumvent these rules. One of those tactics, creating means to make charitable contributions to state-created charities, in lieu of paying certain state income taxes (accomplished by your receiving a state income tax credit based on the qualifying donation), was zapped in new Proposed Regulations. This was as expected, so the new Regs (the affectionate nickname for Regulations) were no surprise. But there are still lots of interesting points about these new Regs to discuss, some other planning options, and insights about what the Act really did.
What’s at Stake?
A lot! Footnote 1 of the Proposed Regs provides: “The Joint Committee on Taxation estimated that the limitation on state and local tax deductions along with certain other reforms of itemized deductions would raise $668 billion over ten years.” The IRS has to be tough as the SALT limitation pays for many of the tax cuts that were the hallmark of the 2017 Act. If the high tax Blue states could facilitate an end-run around the new restrictions the revenue projections for the Act would implode (and many are not particular sanguine about those estimates being realistic in any event).
For taxpayers, few will actually be affected by the Proposed Regs. The Proposed Regulations provide the statistical data to demonstrate this. “After the passage of the Act, which significantly increased the standard deduction, it is estimated that ninety percent of taxpayers will not claim itemized deductions of any kind… It is estimated that approximately five percent of taxpayers will itemize but will not have state and local income tax deductions above the SALT cap.” So, only about 5% of taxpayers will have their state income tax deduction limited by the new rules. Many of those not itemizing will in fact, as promised, be able to file postcard like income tax returns.
But for that 5 % of taxpayers affected by the SALT limitation, they will feel the pain, often severely. Since the contribution workaround was generally eliminated other planning techniques will be noted at the end of this article. But first let’s review the new rules, the limitation and what the Regs do.
How the SALT Work Around Might Have Worked
The idea generally was that if you donated to certain charities you could qualify for a charitable contribution deduction on your federal income tax return. Since charitable donations aren’t subject to any cap, that might have provided a workaround to the SALT limit. You could not deduct your state tax payment, but you might have been able to deduct a contribution you made to charity in lieu of making a state income tax payment. Tax alchemy! If you could deduct on your federal income tax return the full “donation” without limit, unlike the state tax amount that would have been limited, you would have circumvented the new Act SALT restrictions. To foster the workaround, and help their citizens adversely affected by the new law a number of states took steps to permit taxpayers who made donations to certain charities to get a tax credit on their state income tax return for those donations. Abracadabra…until the new Regs.
What the Proposed Regs Do
If the alchemy of transmuting a non-deductible state tax into a deductible donation were permitted the revenue estimates of the Act would have assuredly failed. So, Treasury had to act. Under the new Regs, if a taxpayer makes a payment or transfers property to or for the use of a state charity (listed in Code Section 170(c)), the amount of the taxpayer’s charitable contribution deduction under section will be reduced by the amount of any state or local tax credit that the taxpayer receives or expects to receive in consideration for the taxpayer’s payment or transfer.
Here’s the example from the new Regs: “A, an individual, makes a payment of $1,000 to X, an entity listed in section 170(c). In exchange for the payment, A receives or expects to receive a state tax credit of 70% of the amount of A’s payment to X. Under paragraph (h)(3)(i) of this section, A’s charitable contribution deduction is reduced by $700 (70% x $1,000). This reduction occurs regardless of whether A is able to claim the state tax credit in that year. Thus, A’s charitable contribution deduction for the $1,000 payment to X may not exceed $300.”
This change eliminates the tax benefit of this type of planning in most instances.
FLASH – Act Quickly (Maybe)
The new regulations are only effective on August 27, 2018, so daring taxpayers living in high tax states that have a charitable credit program might opt to make donations and claim their tax credits now. But caveat emptor, the Proposed Regs raise some worries about this tactic.
The amendments to these regulations are proposed to apply to contributions after August 27, 2018. Might the effective date provide a razor-thin window of planning an opportunity to make donations before August 27? Perhaps not given the discussion in the Regs preamble that the quid pro quo rules are based on long-existing case law and Regulations. What that means is that if you make a quick contribution and get a tax credit the IRS might audit your return and apply existing (old) law principles to disallow much or all of that deduction.
But that conclusion is not certain, so you might want to pay quick. This is because the Regs acknowledge that “Prior to this proposed rule, there was no authoritative regulatory guidance on the treatment of state or local tax credits arising from charitable contributions to entities listed in section 170(c), and there was no guidance aside from Notice 2018-54 addressing the interaction between section 170 and the newly enacted SALT cap. As a result, there was a degree of taxpayer uncertainty as to whether state and local tax credits are a return benefit that reduces a taxpayer’s charitable contribution deduction.” This suggests that perhaps prior law was not so clear but there are various possibilities of what wasn’t clear. There may have been only a lack of certainty as to the offset, i.e., the amount of the quid pro quo reduction in a donation you make for the state tax credit you may get. This might really pertain to the determination of the quid quo pro value or offset. In other words, the preamble of the regulations makes clear that a reduction in a donation to reflect a quid-pro-quo was clear under prior law, just not the amount. The proposed regulations address the determination of the amount in the most common circumstances (and that will likely be the amount of the credit). Another interpretation is that the existence of a quid pro quo for state tax credits may not be clear. You have to determine if that is a risk you would like to take.
Other Planning Steps to Address SALT Restrictions if the Charitable Workaround Won’t Work
Well, since the donation in lieu of state tax workaround has been nailed, what else might you do to if you are a five-percenter getting hammered by the new SALT restrictions? Here are a few paths to consider
The Act made havoc of traditional tax planning. More accurately than reducing tax burdens the Act shifted tax burdens. Those living in high tax states that cannot benefit from other tax breaks the Act provided bear much of the cost of paying for the supposed tax cuts. But as the 5% statistic above confirms, those getting nailed are not a large voting bloc in terms of numbers as those getting a small tax break and postcard size tax return. The Treasury and IRS have headed off one strategy to circumvent the unfairness of the new SALT limitations, but other planning avenues remain. By the time all this is sorted out 2026 and the sunsetting of these new rules may be upon us.
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