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What’s the state of the federal deduction for State & Local tax payments?

What’s the state of the federal deduction for State & Local tax payments? Possible alternatives and IRS scrutiny.

New law limits overall deduction for State & Local taxes
The 2017 tax act included a controversial provision regarding the federal individual income tax return deduction for State & Local tax payments. The new rule, effective for the 2018 fiscal year, limits the deduction for the combination of state and local income taxes and property taxes to $10,000.

Workaround alternatives enacted or proposed by several states
Several states, mostly with high personal income taxes, have enacted or proposed workarounds to this new federal provision.

New Jersey, New York, Connecticut and Oregon have all enacted laws that allow taxpayers to claim a state tax credit for charitable contributions to certain state-affiliated funds. There are similar laws pending in other states including Illinois, Nebraska and Virginia.

In addition to these charitable contribution workaround provisions, New York also created a new “Employer Compensation Expense Program” which allows employees to claim a state tax credit if their employer opts into a new payroll tax regime.

IRS scrutiny and taxpayer concerns, including the PA EITC and OSTC programs
Since the new tax law was passed in December, the IRS has been aware of and seems to be focused on preventing attempts to circumvent the $10,000 limit on the State & Local tax deduction. The IRS issued a notice in late December that denied the tax deduction for taxpayer prepayments of 2018 State & Local taxes unless the taxpayer had an actual bill from the taxing authority. This notice thwarted the efforts of many taxpayers to claim a deduction for prepaying their 2018 State & Local taxes.

Therefore, it is not surprising that the IRS has reacted to the efforts by the states to provide workaround alternatives. On May 23rd the IRS issued Notice 2018-54, Guidance on Certain Payments Made in Exchange for State and Local Tax Credits. The notice specifically addresses the efforts by states to circumvent the new $10,000 limit on state and local tax deductions and reminds taxpayers to be mindful that federal law controls the proper characterization of payments for federal income tax purposes. The notice further explains that the IRS intends to propose regulations addressing the federal income tax treatment of transfers to funds controlled by state & local governments that can be treated as satisfying state and local tax obligations.

It is hard to say if or when these proposed regulations will be issued. This process can sometimes take years and is often not completed at all. However, if regulations are issued, it will be important to see what is addressed and how broad the implications will be. Will the IRS focus on these new state legislative initiatives to circumvent the new law restriction OR will the rules ultimately restrict existing state programs that permit charitable contributions to non-government charities to create state tax credits? If the latter, this could affect the benefits of the PA Educational Improvement Tax Credit and Opportunity Scholarship Tax Credit programs.

At this point only time will tell. We will follow any future developments and keep you posted. For additional information contact us at info@herbein.com