While the Tax Cuts and Jobs Act (TCJA) concerns only federal policies, the size and scope of its provisions are having complicating effects on state-level tax planning, as well.
One of the biggest issues is the imposition of a new $10,000 cap on deductions for state and local taxes (SALT), which was previously unlimited. Residents of states with higher taxes, such as New York, had long used this deduction to balance out their federal and state tax burdens. Capping the deduction, however, means that New Yorkers must pay an additional $14.3 billion per year, according to a report from the New York State Department of Taxation and Finance. Catherine M. Censullo, founder and head of Catherine M. Censullo, CPA/CMC Wealth Management, said this has her clients very concerned.
“A lot of people were upset about losing the property tax, local income tax [deduction]. People were very, very upset about that. People were asking about paying next year’s taxes, and that’s not really something you can pay in advance if it hasn’t been billed for subsequent years,” she said.
Many practitioners are trying to find ways they can make up for the loss, such as by experimenting with the use of trusts. Johnpaul Crocenzi, a tax principal at Raich Ende Malter & Co. LLP, and a member of the Taxation of Individuals Committee, said that this is something his own firm is considering.
“Our plan … is to actually have a person set up a trust and have that trust own the real estate for the residence, so that way, if there [are] taxes, it will be fully deductible in the trust return. Because the way the law was written, it doesn’t specify what ‘individuals’ are,” he said.
New York state workarounds
New York state Gov. Andrew Cuomo said that the deductions cap would increase New Yorkers’ tax burden by an unacceptable amount, and called the cap a way to rob blue states in order to finance tax cuts in red states.
In his fiscal year 2019 budget, Cuomo laid out a set of proposed fixes to address the cap on SALT deductions, as well as the TCJA’s doubling of the standard deduction. The state Legislature approved those proposals on March 31. The three workarounds are as follows:
• Giving businesses the option to participate in a new opt-in Employer Compensation Expense Program. Those who choose to take part would be subject to a 5 percent tax on all annual payroll expenses over $40,000 per employee. Since the progressive personal income tax system would remain in place, workers would get a new tax credit meant to ensure that they do not experience a reduction in take-home pay. This would be phased in over three years, beginning on Jan. 1, 2019.
• Creating two new state-operated charitable contribution funds that will accept donations for improving health care and education in New York. The intention is for taxpayers to be able to itemize these contributions as deductions on their state and federal tax returns. Those who make such donations will also be eligible to claim a state tax credit equal to 85 percent of the donation amount for the tax year the donation is made. The new budget also authorizes local government bodies like school districts to create similar charitable funds, donations to which would yield a local property tax credit.
• Decoupling the state and federal tax code. Currently, New Yorkers can itemize deductions on their personal income tax only if they also itemize on their federal returns. Because the TCJA doubles the standard deduction to $12,000 for single filers and $24,000 for married couples, it eliminates the option of itemizing for many federal taxpayers. This new provision will allow New York taxpayers to itemize their New York taxes, even if they can’t do so for their federal taxes. It essentially says that any reference to the laws of the United States mentioned in the state tax law actually means the provisions contained in the Internal Revenue Code and any amendments to it made prior to Dec. 1, 2017.
Society efforts
In the wake of the new federal law, the NYSSCPA has formed a Tax Cuts and Jobs Act (TCJA) Ad Hoc Committee devoted to reviewing and analyzing proposed changes that may develop in New York tax regimes and policy as a result of the legislation. Kevin J. McCoy, the chair of this committee, said that the Society is not currently taking a position on any of the specific proposals coming out of Albany, but has expressed concern about the specifics of their possible implementation.
“Our major concern goes with the complications involved with implementing any of the potential changes,” he said.
The one that raises the most questions, he said, is the payroll tax, because it will involve employers tracking those taxes for their employees and determining the degree to which the new tax would affect their compensation. He also said the tax would likely complicate individual returns because of the need to report the amount of credit that was paid on the taxpayer’s behalf in the form of payroll taxes.
“While it is neutral from a revenue viewpoint, and certainly assists the taxpayers, the complications of implementing and tracking add a burden to the employer. We’d have to determine whether or not the benefit of that outweighs the costs,” McCoy explained.
Chaim V. Kofinas, a senior tax manager at Beacon Partners and a member of International Taxation Committee, is not confident that plans like those in the Cuomo budget would work as intended. The proposed payroll tax, he said, essentially moves the burden from the employee to the employer. This, combined with the increased administrative burden that will come with the tax, would likely make it unpopular with employers. He also noted that it’s far from a comprehensive fix to the problem that Cuomo was addressing.
“This only solves the deduction limitation problem for employees. Sole proprietors and partners are still left without a viable alternative to deduct the payment of state income taxes,” he said.
He then added that it was uncertain that the IRS would accept the idea of making a charitable contribution to New York state. In order for the plan to work, it would need to clear two hurdles: First, the charitable foundation created and administered by the state must pass muster and qualify under Internal Revenue Code Section 501(c)(3). Then, the IRS must still allow a charitable contribution for contributions when the donor (aka, the taxpayer) receives a credit equal to 85 percent of the contribution. “The exposure here is on the taxpayer, not the state,” Kofinas said.
But Philip J. London, a tax partner emeritus at Wiss and Company, LLP, chair of the New York, Multistate and Local Taxation Committee and a member of the TCJA Ad Hoc Committee, said that even if one avoidance measure doesn’t work, states will continue to innovate to find ways around the new cap.
“The states are going to be creative to try and get around this deduction [cap]. Other people believe that [states] like New York and California, which are high-tax states, should somehow adjust their spending and tax structure to reduce the taxes, in order to be more in line with the states that are not as affected by this. However I don’t know if New York state residents would be happy with a reduction in services if there was a reduction in income [given the cap],” he said.
London also said that many New Yorkers hadn’t been able to benefit from the SALT deduction in the first place because they were already falling into the alternative minimum tax (AMT) zone, and so he thought that the impact may not be as widespread as many are thinking.
State and federal law dynamics
Another major effect of the new tax law will be navigating areas where state and federal policies differ. For example, the estate tax, which had generally followed federal rules, now heavily conflicts with the state statute. The federal tax law doubled the estate tax threshold to $11 million for individuals and $22 million for couples (though the threshold then reverts to its 2017 rate in 2026). New York’s estate tax, on the other hand, is currently $5.2 million for individuals. London said that the way things are set up, however, leaves a lot of questions.
“Will they double the phase-in to meet the new federal threshold? And then, with the federal law, when … [in 2026] it reverts back to the current levels, is there going to be a clawback on any gifts made in that time period? The answer is that our esteemed Congress delegated that answer to the secretary of the Treasury,” said London, who noted that there has not been guidance out of the Treasury Department regarding these questions.
Then there are unknowns that can only be properly understood with time, such as how the pass-through entities provision will impact the state. London noted that while a 20 percent deduction on certain qualified business income from a pass-through entity is a federal law, it also leaves open questions on the state level, particularly when it comes to calculating how much exactly someone owes. It’s easy to calculate tax liability for people on salary—just look at their W-2. Similarly, items like investment income or interest income are also easy to calculate, given the clear rules around them. The new pass-through provision, though, is something new, and London said it will be difficult to predict how it affects taxes on a state level without further guidance from the IRS. He added that it was unlikely that the state would adopt a similar provision in order to harmonize with federal law, meaning that the deduction would be calculated after doing itemized deductions but before taxable income.
Still, he noted that much will probably change over the course of a year, and many of the tactics used in reacting to the new tax law will probably wind up being different, as further guidance and clarification are released.
“As I look into the federal law, it was done so quickly and haphazardly that there’s going to be a need for regulations or corrective legislation, technical corrections acts,” he said.
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Impact of deduction caps on the real estate market, entertainment industry
Another major item affecting New Yorkers, in particular, are the changes to the mortgage interest deduction and home equity loan interest deduction. Philip J. London, a tax partner emeritus at Wiss and Company, LLP, pointed out that the mortgage interest deduction cap has been lowered from $1 million to $750,000 until 2026, when it reverts back. He also said that home equity loan interest is no longer deductible. These two changes, when combined with New York’s notoriously high real estate rates, mean that homeowners and prospective homeowners will both be paying more taxes.
However, he didn’t think this tax impact would be particularly devastating. “Many New York City residences are over $1 million, and Westchester and Nassau County, as well, have many multimillion-dollar residences that could be affected, … but it’s only reducing it by $250,000 to $350,000—the interest on that amount. So I don’t think it’s a major effect, but it’s an effect,” he said.
Yet Chaim V. Kofinas, a senior tax manager at Beacon Partners, said that the impact could be larger than the immediate tax impact—the changes could wind up shifting the market in a negative direction. He said that the SALT deduction cap, the lowering of the mortgage interest deduction cap and the end of home equity interest deductions mean that people won’t buy as much real estate. Buying a summer home in the Hamptons, while expensive, is not an entirely unreasonable proposition because of all the deductions and other incentives. Without them, though, many people are going to decide it’s not something they can really afford. This means that the real estate industry will turn increasingly to the demographic that can: the wealthy. This is where the market effect comes in.
“If I took away that deduction for taxes, and I took away that deduction for the mortgage, because I limit you on how much mortgage you can carry, it’s going to have a material effect on your ability [to buy] and it will affect the market. So now the market has to move up a scale, as opposed to being available to the average Joes, because they’re the ones who can afford it,” said Kofinas.
Attorney Mark S. Klein, a tax partner at Hodgson Russ LLP, noted that the new tax law will have a negative impact on the entertainment industry, which is very strong in New York. Speaking at the Foundation for Accounting Education’s “Impact of the New Tax Law: A Sid Kess Workshop” recently, he said that, for years, entertainers were able to deduct most of their agents’ fees, which typically make up 20 percent of whatever it is they make. This is no longer the case, however.
“So, under the new laws, actors, actresses, folks that pay that commission, will pay tax on 100 percent of their income, even though they only get to keep 80 percent,” he said.