Evaluating the Election to Deduct State and Local Sales Tax

By Mark H. Levin

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APRIL 2005 - The American Jobs Creation Act of 2004 (AJCA), section 501(a), creates an opportunity for individual taxpayers to deduct, in computing their taxable income, the amount of state and local sales taxes paid, in lieu of state and local income taxes paid. This election is available for 2004 and 2005.

This provision was designed to benefit taxpayers in states with no state sales tax, taxpayers in states that impose a sales tax that is relatively high compared with the state’s income tax rate, and low-income taxpayers. The provision’s effects, however, reach even further.

State and Local Deductions and Federal Itemized Deductions

The ability to deduct state and local sales taxes in lieu of state and local income taxes can lower the federal income tax for taxpayers residing in states with a low income-tax rate. Some taxpayers residing in states with high sales and income tax rates may, however, also benefit from electing to deduct state and local sales taxes in lieu of state and local income taxes. This is because most states that start with federal taxable income in computing state taxable income require the taxpayer to reduce federal itemized deductions by any amount attributable to state and local income taxes.

The New York State Tax Law, section 615(a)(1), requires a taxpayer to reduce federal itemized deductions by “income taxes imposed by this state or any other taxing jurisdiction” when computing New York State taxable income. There is no corresponding provision in the law requiring a reduction for state and local sales taxes. The California Revenue & Tax Code, section 17220(a), states: “Section 164(a)(3) of the Internal Revenue Code, relating to the deductibility of state, local, and foreign income ... taxes shall not apply.” Other states have similar provisions requiring state and local income taxes, which were deducted in comparative federal taxable income, to be added back in arriving at state or local taxable income.

Taxpayers residing in states whose income tax is based on adjusted gross income (e.g., New Jersey and Pennsylvania) will not realize any benefit from electing to deduct state and local sales taxes in lieu of state and local income taxes unless the potential state and local sales tax deduction exceeds the deduction for state and local income taxes.

State and Local Deductions and the Alternative Minimum Tax

Consider the following hypothetical set of facts: A New York resident taxpayer is subject to the federal alternative minimum tax (AMT). Her AMT taxable income (AMTI) is greater than the state and local income tax deduction claimed in her federal tax return. The taxpayer has an AMTI of $40,000, a state and local income tax deduction of $15,000, and a potential sales taxes deduction of $5,000.

If the taxpayer elects to deduct the $5,000 state and local sales tax in lieu of the $15,000 state and local income tax, there will be no change to her federal income tax, as neither state and local income taxes nor state and local sales taxes are deductible for AMT purposes. There is no requirement, however, to reduce the federal itemized deductions by state and local sales taxes when computing the New York State personal income tax, so the New York State taxable income will be lower with the federal deduction for state and local sales taxes than if the taxpayer had taken a federal deduction for state and local income taxes.

Care must be taken when preparing 2004 and 2005 tax returns to ensure that the taxpayer is getting the benefit of whichever of the above deductions will result in the lowest combined federal, state, and local income tax.


Mark H. Levin, CPA, is manager, state and local taxes, at H.J. Behrman & Company, LLP, New York, N.Y.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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