2018 has been an amazing year for tax practitioners. Since the passage of the 2017 Tax Cuts and Jobs Act, practitioners have been scrambling to understand the implications of the federal tax overhaul and to begin implementing new strategies for clients. And though the legislation obviously occurred at the federal level, many SALT practitioners have been dealing with the dramatic fallout at the state level as well, since aspects of the federal tax reform have had complicating and unexpected ramifications for state tax purposes. States in turn have been scrambling to update their laws to account for federal tax changes and, as will be discussed in this article, take measures to combat the negative impact of the federal tax on its own taxpayers.
The Lost SALT Deduction
The one federal tax change that may be the most basic—but most dramatic—is the near-elimination of the state and local tax (SALT) deduction. Under the new rules, taxpayers generally can only deduct up to $10,000 of SALT payments as itemized deductions for personal income tax purposes. For individuals in high-tax states, this could be the most impactful issue in the entire federal tax reform package. Indeed, historically more than half of the deduction was used up by high-income taxpayers from New York, California, New Jersey, Illinois, Texas, and Pennsylvania, so it goes without saying that the loss of this deduction is extremely meaningful for many taxpayers.
For example, under prior law, if a New York resident paid $50,000 in New York income taxes, he or she would be entitled to deduct that payment from their federal taxes. Thus, assuming the taxpayer was in the highest tax bracket and not otherwise in the alternative minimum tax (AMT), the payment of $50,000 in New York tax would only cost that taxpayer around $30,000, owing to the federal tax benefit of the deduction. Now, however, assuming the taxpayer uses the $10,000 cap for other New York taxes such as property tax, he receives no deduction off of federal taxable income. Thus, a $50,000 payment of New York taxes actually costs the taxpayer $50,000. And obviously, when we get to the taxpayers at higher income levels, the negative impact of this change continues to multiply.
State Responses
In response to this problem, states such as New York, Connecticut, and New Jersey have proposed (and in some cases, passed) legislation to soften the impact of the lost deduction. New York, for example, responded to the lost SALT deduction by enacting or proposing a number of different and potentially controversial measures.
The first thing New York did was enact a voluntary payroll tax, called the Employer Compensation Expense Program (ECEP). The point of this rather unusual tax is essentially to shift the employee’s individual income tax burden to the employer. Why would New York do this? Under the federal tax reform rules, individuals are not able to deduct state and local taxes, but businesses are. So the theory here is to shift the deduction from the employee—who couldn’t deduct it—to the employer, who can.
But New York’s new tax is fraught with complexity and difficulty. The most notable difficulty is that in order for the economics of the tax to work, the employee’s salary would need to be reduced to reflect the fact that the employer was essentially taking over some portion of the employee’s state tax burden. Good luck explaining that to the employee! Moreover, it’s very possible that many employees are not even impacted by the loss of the SALT deduction, either because they never itemized their deductions anyway or because the impact of the deduction was limited because of the federal AMT. Therefore, the transition to this employer-based tax would do them no good, and simply cause unnecessary confusion in the company. It also likely would cause difficulties for employees who lived in one state but worked in New York, since the employee’s home state would likely not give credit for the payment of the payroll tax by the employer. (Interestingly, the State of Connecticut, which has done its share of tax reform countermeasures as well, recently passed a law that would allow its residents a credit for NY ECEP paid on their behalf by their employer. No other states have passed a similar measure though.) The good news is that the ECEP tax is voluntary. It’s unclear really if anyone will actually ever sign up for it.
New York also enacted new rules designed to take advantage of charitable deductions. The concept here is for the New York taxpayer to make contributions to New York "charities" in exchange for credits against their New York taxes. If this sounds to you like this shouldn’t work, you would probably be right! The IRS has already come out with proposed regulations designed to shut down techniques like this, so taxpayers thinking about taking advantage of these provisions that New York or other states passed should be wary.
Finally, New York has also proposed a new unincorporated business tax, with the concept again to shift the tax that would normally be paid by individual partners to the partnership because the partnership would be entitled to deduct the tax. This tax, unlike the payroll tax, would be not be voluntary, and could cause many of the same problems and issues that the payroll tax would be likely to cause. For now, New York is still considering whether to implement this, so we’ll have to wait to see if it is included as part of the Governor’s executive budget in January 2019.
As noted, other states are taking similar measures, including Connecticut. Connecticut actually has enacted a new tax on pass-through entities designed to shift the tax burden from the owners of these entities to the entity itself. This law was enacted in May 2018 and was actually made retroactive to January 2018. So, it is in full force and effect right now! Any flow-through entity, including an S corporation that does business in Connecticut should be paying attention to this. California and New Jersey have also passed measures allowing taxpayers to make charitable deductions in place of tax payments, and similar legislation has been proposed in Illinois, Nebraska, Virginia and Washington.
Will any of these workarounds actually work? At this point, it’s hard to say. As noted above, the charitable deduction workarounds are already in the IRS’s sights, and many of the other workarounds are complicated and will be difficult to implement. So it doesn’t appear like these workarounds will solve the problem.
The Most Effective Workaround?
From previous experience, the most basic and simple response to deal with the loss of the SALT deduction for taxpayers in high-tax states is simple: move from that high-tax state! This doesn’t require any complicated income shifting. And it doesn’t require state laws designed to circumvent federal laws. It just requires a taxpayer to pack up their stuff and move to another state.
I’ve had direct experience with this recent phenomenon, having received probably more than 100 calls from clients or potential clients looking to explore the possibility of moving from a high-tax state like New York to a low-tax state like Florida. Those who were once comfortable with paying high state taxes because of the federal benefit are now are unwilling to be so generous with their tax dollars. And while this is obviously just anecdotal evidence, I expect a significantly increased volume of taxpayers looking to change residency—or attempting to change residency—this year or next. Thus, I also expect a barrage of personal income tax audits in high-tax states like New York, Connecticut, New Jersey, and California in the coming years.
This brings up one critical point about such a strategy. If the taxpayer seeks to change residency to a low-tax state to lessen the impact of the lost SALT deduction, there is one critically important thing to keep in mind: they actually have to change their residency! As many former New Yorkers have learned, changing residency from one state to another is not as simple as getting a driver’s license and spending a certain number of days outside a jurisdiction. State residency laws require taxpayers to prove that they “left” their old state with the intention of not returning and “landed” in a new jurisdiction with the intention of residing there at least on an indefinite basis. Proving this is not an easy task, so making sure you know the rules is key. States like New York require that the taxpayer present “clear and convincing evidence” of the change, so any doubt gets resolved in favor of the relevant state tax department.
This, of course, presents an interesting conundrum. While state tax departments like New York are doing everything they can to help their residents deal with the loss of the SALT deduction, it is extremely unlikely that they will look favorably on those whose strategy involves jumping ship. No, to the contrary, we can expect the states to be extra vigilant about making sure that such taxpayers are honestly and legitimately claiming a change of residency, and that they are taking actions in support of such a change.
Despite these concerns, changing residency to deal with the loss of the SALT deduction is absolutely an effective strategy, and will likely prove to be the most effective strategy for dealing with this issue. But, like the other workarounds, we expect it may also end up subjecting the taxpayer to audit and litigation.
Timothy P. Noonan, JD, is the practice group leader of Hodgson Russ LLP’s New York Residency Practice, and he is one of the leading practitioners in this area of the law. He has handled some of the most high-profile residency cases in New York over the past decade, including the Gaied case discussed here, one of the first New York residency cases to ever reach New York’s highest court. He also co-authored the 2014 edition of the CCH Residency and Allocation Audit Handbook, and he is often quoted by media outlets, including the Wall Street Journal, New York Times, and Forbes, on residency and other state tax issues. As the “Noonan” in “Noonan’s Notes,” a monthly column in Tax Analysts’ State Tax Notes, Tim is also a nationally recognized author and speaker on state tax issues. He can be reached at 716-848-1265 or tnoonan@hodgsonruss.com.