IRS And States to Fight Over Income Tax Deductions for State and Local Taxes

AdobeStock_71412567-300x194States, including Connecticut, are looking for loopholes to soften the impact of a new $10,000 cap on the state and local tax deduction also known as SALT.  And the IRS wants to put a stop to local governments using creative workarounds.

In the meantime, in response to the reform, Connecticut legislature passed a new law making several state and local changes. Two of its provisions are designed as workarounds to SALT:

  1. The first provision is a new entity-level income tax on most pass-through businesses that is offset by a state personal or corporation income tax credit for the entity’s members. Because entity-level taxes remain deductible at the federal level, pass-through businesses will be able to claim this new state tax as a deductible expense against their federal taxes and pass along the benefit of the deduction to their members.
  2. The second provision is that municipalities will be allowed to provide a property tax credit to eligible taxpayers who make voluntary payments to municipally-approved nonprofits (i.e. community supporting organization) and is designed to allow taxpayers that make these payment to claim a federal contribution deduction for the donation to the nonprofit.

But the IRS, in Notice 2018-54, published May 23, 2018, stated it intends to propose regulations addressing the federal income tax treatment of transfers to funds controlled by state and local governments (or other state-specified transferees) that the transferor can treat in whole or in part as satisfying state and local tax obligations.

The proposed regulations will make clear that the requirements of the Internal Revenue Code, informed by substance-over-form principles, govern the federal income tax treatment of such transfers. The proposed regulations will assist taxpayers in understanding the relationship between the federal charitable contribution deduction and the new statutory limitation on the deduction for state and local tax payments.

The SALT wars have begun! Stayed tuned to see how it plays out.


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