New York is first out of the gate among states looking to find a way around new caps on the federal deduction for state and local taxes. And with the possibility of Treasury or Congress moving to strike down the measures, the Empire State may prove a test case for similar efforts.
Last year’s tax-overhaul bill capped the federal deduction for state and local taxes, known as SALT, at $10,000, an effort to help pay for lower individual and business rates. The move, along with a few other provisions, raises some $650 billion over a decade, according to the Joint Committee on Taxation.
Lawmakers in high-tax states like New York, California, and New Jersey have fought the provision since its inception, and some have announced plans to change their own laws to let residents avoid the new cap. New York’s budget, passed in Albany on Saturday, marks the first effort to write a workaround into state law books, and the federal government’s reaction could serve as a bellwether for attempts in other high-tax states.
New York Gov. Andrew Cuomo—a potential 2020 Democratic presidential candidate—helped lead a collection of state governments in opposing the SALT cap as the tax bill made its way through Congress, and he has threatened a lawsuit to fight the provision.
“We had to restructure our tax code to avoid the attack,” Cuomo said Friday as he announced the budget. “They launched a missile. We were standing in the target zone of the missile because of our tax code.”
As part of a budget deal reached Friday and passed Saturday in Albany, New Yorkers will have two options to avoid the new cap on SALT deductions, one using payroll-tax rules and another using the federal charitable deduction.
Other states including California, Illinois, and Washington have proposed similar schemes but have yet to move anything out of their state capitols. In New York, neither of the two new workaround options would be mandatory, but both come with potential problems.
The first option would set up a charitable trust to which state taxpayers could donate what they owe in property taxes. Taxpayers could then deduct that amount from their federal tax liability as a charitable deduction, which has no cap.
But Jared Walczak, a senior policy analyst at the Tax Foundation and critic of the workarounds, said that if the federal government is successful in striking down the charitable scheme, state taxpayers could be on the hook. If New Yorkers take advantage of the charitable-contribution workaround, and then the IRS issues guidance disallowing it—and wins a potential court challenge—taxpayers will have overpaid the state without being able to recoup that money through the federal tax deduction.
So far, the IRS has not said it would issue guidance on the SALT workarounds, something Walczak noted is not surprising given that until now no state has tried to implement a plan. But in statements this year, Treasury Secretary Steven Mnuchin has called such proposals “ridiculous,” while House Ways and Means Committee Chairman Kevin Brady has dubbed them “dead on arrival.”
Most analysts say action on the charitable-contribution workaround is coming, though a Treasury spokesperson did not return a request for comment on New York’s latest moves.
The IRS, meanwhile, does have some time to react. Most New York taxpayers will not face the new rules until the 2019 filing season, though some high-income taxpayers have quarterly filings.
The other option would convert the state income tax into a payroll tax paid by employers, with an accompanying employee-income-tax credit. The plan would lower gross pay but make net income equal through a tax refund. That plan, though, may run afoul of both workers and businesses, who may not want the extra burden of dealing with a complicated workaround.
The payroll portion may be on better legal footing, Walczak said, but its complexity may make it an unpopular choice. Congress could still move to stop it, theoretically, but it may be difficult.
From a process perspective, Republican lawmakers are pushing for Congress to move a bill fixing errors in last year’s tax bill, and such language could ride on that measure. But the states most affected by the SALT cap are high-tax, blue states, and Democrats are unlikely to want to nix the workaround. Moreover, Democrats have been able to hold up any technical-corrections legislation and have been successful in demanding concessions on other tax policy in exchange for individual fixes.
That doesn’t leave many legislative vehicles on which to pass language preventing the state workarounds. There is a proposed overhaul of the IRS in the House, and a spending bill in September, but adding controversial language opposing the state provisions may further complicate passing those measures.
And Congress may be wary of trying to limit a state’s authority to levy payroll taxes, or trying to limit the deductibility of business taxes.
“You would need to devise some sort of system that makes the distinction based on the offsets, but that gets incredibly complex,” Walczak said. “It’s within the realm of possibility that Congress would do that, but one suspects that the practical challenges of implementing a payroll-tax-based SALT avoidance are going to be enough to make this a relatively modest program with limited impact.”
That’s because in the short term the payroll provision is most likely to help only employees of small companies made up of mostly high-wage earners, like hedge funds or law firms, Walczak wrote in a Monday blog post on the Tax Foundation’s website detailing the workarounds.
A spokesperson for the Ways and Means Committee didn’t return requests for comment on whether the panel was preparing a legislative response.
Jonas Shaende, senior budget and policy analyst at the New York-based Fiscal Policy Institute, supports the direction taken by the governor, but said lawmakers should have reviewed their proposals further to root out any unintended consequences.
One of those could be the way the payroll-tax option affects residents in New York City, which has its own income tax. The city may have to change its own tax law to decouple itself from state rules, or change its income tax to a payroll tax as well, said Shaende, who was part of a roundtable discussion on the issue with the governor’s office earlier this year.
“There is a possibility that the adjustment is going to be smooth and is going to be painless, but at this point it’s not clear that is going to be the case,” Shaende said. “So maybe we are going to be back to the drawing board if the IRS challenges these schemes, or if the benefit for this reform isn’t going to reach the people who need to be reached.”