Over the weekend, New York became the first state to create a state and local taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. (SALT) deduction cap workaround—two workarounds, in fact, since New York does nothing on a small scale. Yet while the newly adopted budget encourages high-income taxpayers to take advantage of these provisions, they ought to come with a warning. Taxpayer Beware: these avoidance schemes may increase your total tax liability. They might even get you auditA tax audit is when the Internal Revenue Service (IRS) conducts a formal investigation of financial information to verify an individual or corporation has accurately reported and paid their taxes. Selection can be at random, or due to unusual deductions or income reported on a tax return. ed.
New York’s effort to preserve what amounts to a federal subsidy for high-income earners in a high-tax state comes in two flavors: a voluntary payroll taxA payroll tax is a tax paid on the wages and salaries of employees to finance social insurance programs like Social Security, Medicare, and unemployment insurance. Payroll taxes are social insurance taxes that comprise 24.8 percent of combined federal, state, and local government revenue, the second largest source of that combined tax revenue. and a contribution in lieu of taxes scheme. The first is an administrative nightmare that is only likely to benefit a select few; the second is a legally suspect workaround which actually increases New York tax payments while holding out the dubious hope of federal tax savings by pulling one over on the Internal Revenue Service (IRS).
We have explored these proposals, and their legal and practical shortcomings, at length in the past. (See, for instance, here and here.) In simple terms, both provisions attempt to preserve the full value of the SALT deduction (capped at $10,000 under the new law). One creates an employer-side payroll tax (which is deductible) with an offsetting employee-side income tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. in the same amount. The other sets up funds for various public (and otherwise tax-supported) purposes, for which the taxpayer is supposed to be able to tax the charitable tax deductionA tax deduction is a provision that reduces taxable income. A standard deduction is a single deduction at a fixed amount. Itemized deductions are popular among higher-income taxpayers who often have significant deductible expenses, such as state/local taxes paid, mortgage interest, and charitable contributions. , and offers a credit in a slightly lesser amount against income tax liability.
The new payroll tax may pass legal muster, but it helps very few taxpayers. For it to work, employers must be able to reduce compensation of their employees by the amount of the payroll tax obligation they voluntarily take on. This might work in theory, since employees are—or at least could be, absent the complexities attendant to the new system—better off under the arrangement, but in practice, wages are sticky. Employers can’t just slash salaries willy-nilly, even if there’s a good argument for it being to the employees’ benefit. There are contracts, labor agreements, minimum wage laws, and human nature to deal with. It might be an option for small groups of highly-compensated employees – think hedge funds and consultancies – but it’s a tough sell for a larger operation with a more diverse workforce.
Then there’s the charitable contribution option, which is supposed to be available to all taxpayers who itemize, though if New York lawmakers had any confidence in their scheme, why bother with the payroll tax option, which is rendered duplicative?
The IRS is highly unlikely to go along with this charade, as these so-called contributions bear none of the hallmarks of genuine charity. The recipient (in this case, the state or a state-linked fund) receives only a modest benefit, quite small in terms of the overall “contribution”; the donor’s “gift” is motivated by personal financial benefit; and the contribution imposes a liability (in the form of the required compensatory credit) on the recipient. This is not a gift; it is a tax avoidance scheme.
What’s worse, it’s not even a particularly good one.
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There’s no doubt that the approach is creative, but a good tax avoidance option must be more than that. It also must be legal, preferably unambiguously so. There are many reasons – including existing case law, guidance, and regulations, along with some strong hints from the U.S. Department of the Treasury – to believe that the scheme will fail.
One hopes that the IRS will clear up any uncertainty with formal guidance before taxpayers try to take advantage of this legally dubious scheme, but if that doesn’t happen, New York could be setting its residents up for a fall. They could face audits; they might be exposed to tax penalties; and their tax liability could actually go up.
That’s because the tax credit New York offers isn’t dollar for dollar; it’s 85 percent for state tax liability and 95 percent for local liability. Someone trying to convert $50,000 in state and $50,000 in local tax liability into a deductible charitable contribution writes a $100,000 check to a new state-established fund, then gets tax credits against income tax liability worth $90,000.
If the IRS were to smile upon this scheme, high-income New Yorkers and the state government both win (though all other taxpayers, subsidizing this largesse, lose): the taxpayer gets a $100,000 federal tax deduction, worth $37,000 in lower federal taxes if all of it is exposed to the top marginal rate, while New York collects more revenue from that taxpayer than it otherwise would. On net, New York is up $10,000 and the wealthy taxpayer is up $27,000. Win-win, except, again, for the taxpayers nationwide who have to make up the difference or bear the cost of lower federal revenues.
If the federal deduction is disallowed, however, on the grounds that it is transparently not a charitable contribution – a fact New York is advertising by selling the entire program as an intentional tax avoidance scheme – then this taxpayer has overpaid New York by $10,000 (which can’t be recovered) and gets nothing from the federal government except, perhaps, an audit.
If New York really wants to lend taxpayers a helping hand, it should make its own tax code more competitive rather than trying to mask its own shortcomings with legally-suspect avoidance schemes which are likely to backfire on taxpayers.Share