How the Tax Cuts and Jobs Act Affects State Taxation
Headache or Windfall for States?
The TCJA has created both headaches and windfalls for states, related to two primary issues. First, the limit on the federal deduction for state and local income tax along with real estate taxes, capped at $10,000 each year, has created pressure for some high-tax states such as NY, CT, CA, and NJ to look at ways to circumvent the limitation. These tax schemes are a direct result of pressure from state residents to find a way to reduce state taxes if the federal exemption is lost. Since the states will not seek to cut state taxes, the next best strategy is to convert the state income tax into an item that is deductible at the federal level. This concept has taken on two primary plans that have varying degrees of benefit to state residents.
The first revolves around states setting up state-run charitable entities to which residents can make voluntary contributions. The benefit for the resident is that the contribution will provide a credit that the resident can use to offset state income tax. Recommendations have also been made for local cities and towns to do the same in relation to real estate taxes.
The proposed program would work as follows: The state taxpayer would contribute $10,000 in cash to such a charity and, as a result, receive a tax credit of $10,000 to offset state income taxes. The contribution would be deductible at the federal level as a charitable contribution;
Unfortunately, the IRS has negated the benefit of this strategy by requiring the benefit received by the resident to offset the contribution. So in the example above, the resident would receive no contribution benefit, since 100% of the contribution would be returned as a tax credit. The only way to get a federal deduction would be for the tax credit to be limited to $5,000, at which point the contribution would then be $5,000. It is unlikely that anyone would seek to apply this strategy since the $10,000 state tax cost has now risen to $15,000 albeit, with a $5,000 federal charitable deduction.
The second issue created by the states is a method to convert state income taxes into corporate deductions via a new payroll tax in New York and a tax on pass-through entities in Connecticut. The IRS response to these strategies is somewhat unknown, but will be addressed fairly quickly in 2019 since, while New York has held off on its payroll tax until January 1, 2019, CT implemented its pass- through entity tax for 2018, so its application will affect 2018 tax returns.
The Connecticut Pass-Through Entity Tax is a 6.99% tax on the income of partnerships or S-corporations that are taxable in CT. There are two methods to calculate the tax: the standard method and the alternative method. For simplicity, we’ll only discuss the standard method, which is the default unless an election is made to use the alternative method.
Example 1:
PE has $1,000 of ordinary income and has no other income. PE conducts business both within and without Connecticut and determines, based on facts not stated in this example, that its apportionment fraction is 10%. In this situation, PE has $100 of Connecticut source income ($1,000 * 10%) and a PE Tax liability of $6.99 ($100 * 6.99%).
Example 2:
PE has $500 of Connecticut source income, including a distributive share of $200 of Connecticut source income that it received from Sub PE. PE is a partner in Sub PE. Sub PE filed a PE Tax Return and paid the PE Tax due. PE is subject to tax on $300 ($500-$200) of its Connecticut source income and has a PE Tax liability of $20.97 ($300 * 6.99%).
The partner in the entity is then entitled to a PE tax credit equal to 93.01% of the partner’s share of the PE tax liability. A partner’s share of the PE tax liability is determined based on the percentage of the partner’s distributive share of income that is included in the PE’s income, subject to the PE tax. Since the 6.99% PE tax is the highest personal income tax rate in CT, it is likely that the resident and non- resident partners will receive a credit in excess of their CT tax. The excess credit is treated as an overpayment and can be refunded to the partner. This strategy, thereby, converts the distributive share of income from a pass-through entity into a tax deduction on the entity which in turn reduces federal taxable income of the PE by the CT income tax that would be paid by the CT partners or shareholders.
The IRS has not provided any comment on how it will view this tax strategy, but with returns due in March of 2019, taxpayers should expect some guidance by the end of 2018.
This issue in Connecticut helps owners of pass-through entities, but does nothing for those earning wages, which is being addressed by the New York Employer Compensation Expense Tax (ECET). This is a tax on the employer for wages paid to employees earning in excess of $40,000 annually beginning in 2019. The tax is being phased-in over three years as follows:
- 1.5% in 2019.
- 3% in 2020.
- 5% in 2021 and subsequent years.
Employers that wish to participate in the ECET must make an annual affirmative election by December 1 to pay the optional tax in the following calendar year. Thus, the initial annual employer election must be made by December 1, 2018, for employers wishing to participate in the program in 2019. The New York State Department of Taxation and Finance will be providing a web-based registration system to facilitate the employer election into the ECEP.
Once the election is made, employers will be required to pay the ECET electronically on the same dates as the employer’s withholding tax payments are required to be made. Filing dates for the quarterly ECET returns will also mirror the due dates of the employer’s withholding tax returns.
Employers are prohibited from deducting or withholding any portion of the tax from the employee’s wages. Covered employees making over $40,000 will receive a credit when filing their personal income tax return and should review their 2019 Form IT-2104, Employee’s Withholding Allowance Certificate, which will be updated to allow employees with wages subject to the tax to adjust their income tax withholding accordingly.
It should be noted that the IRS has not yet confirmed whether employers will be able to offset their federal income tax liability by taking a deduction based on payroll taxes paid to New York State under the framework of the ECET. Until the IRS provides further clarification as to the validity of employer deductions based on the ECET, employer incentives to participate in the program will remain unclear.
While this program appears beneficial, it is entirely voluntary by the employer, and since they cannot reduce employees’ wages by the tax, it is unlikely that many employers will make the election. The only way that it appears to be a workable solution for employers is if employees forgo annual raises in favor of the employer electing to pay the ECET. Were that to happen, it is not clear how the IRS would view this system, as the employee is obtaining a benefit in the form of a tax credit, and the IRS could determine that to be income, thus defeating the benefit to the employee.
Other states have espoused plans to implement similar strategies and are looking at the reaction of the IRS to these two plans. It is likely that whatever issue the IRS may take with either the CT or NY plans will then be adapted by the next state, until completely workable plans are implemented. The other issue out there is that the attorney generals of CT, NJ, NY, and MD have stated their intentions to sue the IRS, should it seek to impose restrictions on these workaround statutes. So, the issue bears watching to see who will blink first: the IRS or state government. Unfortunately, individual taxpayers are the ones in a state of limbo while state and federal governments rattle their sabers.
