Washington – The Internal Revenue Service and the Treasury Department said Wednesday they intend to issue regulations to rein in an attempt by Connecticut and other states to get around a new limitation on the deductibility of state and local taxes.
In its notice, the IRS and Treasury Department made clear that federal law — not states — controls the characterization of payments.
“Despite these state efforts to circumvent the new statutory limitation on state and local tax deductions, taxpayers should be mindful that federal law controls the proper characterization of payments for federal income tax purpose,” the IRS notice said.
The new federal tax overhaul, called the Tax Cuts and Jobs Act, limited the amount of state and local taxes an individual can deduct in a calendar year to $10,000.
It was widely seen as punishing so-called “blue states” controlled by Democrats where taxes are often higher than in GOP-dominated “red states.”
In response to this new limitation, Connecticut and other states adopted proposals to allow taxpayers to make payments to specified entities in exchange for a tax credit against state and local taxes owed.
Leigh Appleby, spokesman for Gov. Dannel Malloy, sponsor of the workaround, said “it’s no surprise that the Trump administration is once again targeting Connecticut taxpayers.”
“The Republican tax law disproportionately hurts families in our state and is an affront to the middle class,” Appleby said. “The legislation proposed by the governor and passed overwhelmingly by the General Assembly gives municipalities a workable option to ensure their residents aren’t double taxed because of the Trump/GOP tax law.”
That new state tax bill, which Malloy has not signed into law yet, allows municipalities in Connecticut to create “community supporting organizations” classified as charitable organizations. Taxpayers would make “contributions” to these organizations that are credited toward their tax liability.
Since there is no cap on charitable donations in the new tax law, this would allow Connecticut taxpayers to avoid the $10,000 cap on SALT tax deductibility.
That cap may not affect residents of lower income states like Alabama or Arkansas, but the Tax Policy Center says the average New Yorker’s SALT deduction was $22,169. In New Jersey and Connecticut, those amounts were $17,850 and $19,665, respectively.
“An Act Concerning Connecticut’s Response to Federal Tax Reform,” the name of the new state tax bill, also imposes a 6.99 percent income tax on most pass-through entities and provides a credit to offset the tax at the personal or corporate income tax level.
That is aimed at helping a sole proprietor of a business, a person in partnership or owner of a limited liability corporation increase their federal deductibility of the state income taxes they pay. While the new federal law limits the amount of state income tax that is deductible, business taxes continue to be fully deductible.
Although it will take weeks for the IRS to finish its proposed new regulation, the agency’s announcement on Wednesday makes it highly unlikely Connecticut’s new tax plan will ever be fully implemented.
The IRS notice said:
“The Treasury Department and the IRS intend 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.”
House Ways and Means Chairman Kevin Brady, R-Texas, the main author of the federal tax overhaul that limited SALT tax deductibility, said “I applaud the administration for responding to these gimmicks.”
“There are many mayors and governors who do a good job of balancing budgets and creating jobs in their communities without high taxes, and I encourage those few states that are trying to undermine our growing economy to instead focus on how they can lower their own taxes on their constituents and keep moving our economy forward,” Brady said.
The Connecticut Conference of Municipalities, which represents the state’s cities and towns, said it has consulted with a number of town attorneys who are reviewing the state legislation and the IRS rules in an effort to advise municipal leaders.
“While we are appreciative of the Governor’s and the Legislature’s attempt to help residential taxpayers,” a CCM official said. “We cannot escape the fact that Connecticut’s property tax is regressive, uncompetitive nationally and the federal tax reform bill makes it even more so. It further underscores the need to enact real property tax reform which, as an organization, we strongly support. ”