Blue states are desperate to rescue high-income taxpayers who lost a federal write-off. Odds are poor.
Those schemes to resurrect the federal deduction for state income taxes—will they work? Probably not.
The various mechanisms proposed by politicians in high-tax states are destined to be strangled by their own complexity, shunned by taxpayers they are supposed to help or kiboshed by the federal government.
Such was the grim assessment from a trio of experts convened March 29 by the Manhattan Institute. Speaking to an audience of fretful taxpayers, the panel laid out all the reasons why it will be next to impossible to turn stiff state tax bills into federally deductible items.
States like California, Connecticut and New York are in trouble. They are very dependent on taxes collected at the high end of the income scale. But prosperous taxpayers refuse to stay put. They are migrating to lower-tax states like Washington and Florida.
The federal tax cut enacted last year makes matters worse for the big spenders in Albany and Sacramento. For 2018 and later tax years, it caps the federal deduction for state and local taxes at $10,000, a trifling sum for one-percenters. For most of the well paid, the allotment will be more than eaten up by property taxes, leaving no value to deducting any state income tax. Result: For the first time in a century, prosperous taxpayers will be feeling the full brunt of local taxation.
In 2017 the effective state/local income tax bracket for New York City dwellers topped out at 7.7%, net of the benefit from deducting those taxes on a federal return. This year the number kicks up 5 points to 12.7%. “This is uncharted territory,” said E.J. McMahon, research director at the Empire Center for Public Policy.
Blue-state politicians have come up with three schemes to replace what their high-income citizens lost in the 2017 tax law. All three look doomed.
Scheme #1. Turn tax payments into charitable contributions. Instead of paying $100,000 to the state tax department, you’d chip that in to some nonprofit entity doing useful things like paying teacher salaries, and claim an itemized deduction for charitable contributions (still allowed under the Trump tax code). Then you’d get a credit of perhaps $85,000 against your state taxes.
There’s some theoretical justification for this, Andrew Mason, a tax partner at Sullivan & Cromwell, told the group. In some states a taxpayer can donate money to a private school and claim both a federal deduction and a state tax credit. But there’s also a rule against getting a quid pro quo alongside a deduction. If you donate $250 to a charity and get in return a $200 Yankees ticket, you can deduct only $50.
Is the proposed state tax credit more like a Yankees ticket or more like any other state tax incentive for good behavior? One could argue either side of that.
Here’s the practical problem. The Internal Revenue Service could issue a ruling declaring charity deductions of the sort envisioned in California and New York to be invalid. Even if that ruling were eventually overturned in court, it would have a big impact. Taxpayers claiming the deduction, Mason said, would probably find their tax preparers insisting that the questionable deductions get flagged on their Form 1040s.
Would you make a $100,000 donation to a state charity under those circumstances? You’d be sending in a return begging to be audited, and if you lost an audit battle you’d be out some real money, assuming the state credit is less than 100% of the donation.
If the IRS doesn’t act, tax writers in Congress might step in with a statute forbidding this sort of charitable deduction. They would be highly motivated, said Scott Drenkard, an economist at the Tax Foundation. They need limitations on itemized deductions to pay for the corporate tax cut.
Scheme #2. Replace some of the state income tax with a payroll tax. The payroll tax would go directly from the employers to the state and be a business expense clearly deductible by them. They would reduce salaries accordingly.
Your $1 million pay would be sliced to, say, $950,000, and your state income tax from $80,000 to $30,000, so you’d be even there. But you’d be paying federal income tax on only $950,000.
Clever, no? Maybe not.
Consider an employee who works in Manhattan and lives in New Jersey. As the law stands now, this worker gets a credit against New Jersey tax for personal income tax paid to New York. (Without that feature of tax law, commuters would be double-taxed.) In the payroll substitution scheme, a reduction in New York personal income tax would do a commuter no good because his home-state tax bill would go up by whatever he saved in New York. So the payroll scheme would work for New York only if New Jersey and Connecticut buy in, said Mason. It would be an administrative mess.
The salary switcheroo also won’t work unless all of a company’s workers like the idea of having their pay reduced. This is improbable.
Scheme #3. Replace some of the state income tax with an unincorporated business tax. The UBT is a well-entrenched device that New York City uses to extract extra income tax from people who are partners or self-employed. It’s rapacious, but it does have the virtue of being a federally deductible business expense, as opposed to a personal deduction.
New York’s tax department has seized on the idea of broadening the UBT and making it creditable against personal income tax, Mason said, but hasn’t come up with statutory language to accomplish the task. This is another great idea that will probably go nowhere. “Without reciprocity from Connecticut and New Jersey it would be an absolute disaster,” he said.
It is quite a wonder to see big-spending governors like Andrew Cuomo striving to cut the federal tax bills of the upper class. If they don’t succeed, the cost of local taxation will come into sharp focus a year from now, when 2018 returns are filed. More people will vote with their feet.
Do you reside in both Manhattan and Florida? And is your work the kind that can be done anywhere you can bring a laptop? If you haven’t already, contemplate arranging your affairs so that you spend 183 days a year in Florida.
Be prepared for a fight when you file your first non-resident return in New York, advises tax lawyer Mason. The form compels you to disclose that you still have that apartment in Manhattan. You’ll need very good documentation of where you were each day.
Related story: Financial Sinkhole States in the Trump Tax Era.
Originally published at Forbes