Earlier today, the Internal Revenue Service issued a notice announcing forthcoming regulations and guidance clarifying the treatment of income recharacterized for purposes of working around the new $10,000 cap on the 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. Thus far, New York, New Jersey, and Connecticut have passed legislation designed to enable high-income taxpayers to circumvent the cap, with legislation pending elsewhere. In the notice, the IRS emphasized the “substance over form” doctrine, meaning that the IRS cares about the actual substance of a payment, and not the name or form it may be given.
While the actual guidance remains forthcoming, this is clearly bad news for the charitable contributions in lieu of taxes approach, as the IRS has underscored in this notice that it is concerned with whether a payment is made in satisfaction of tax liability, and not whether it is recharacterized in some way. The impact on other workarounds, such as New York’s optional payroll tax swap or Connecticut’s entity-level tax swap, is not immediately clear, though both approaches could be at risk as well.
The IRS may well determine that when a company remits 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. to obtain an offsetting 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. against its employees’ individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. liability, that company is actually paying income taxes on behalf of its employees—which is perfectly legal, but which would not succeed in avoiding the cap. Moreover, federal definitions of individual income include pass-through income, casting doubt on the viability of entity-level tax swaps.
We have repeatedly counseled skepticism of SALT deduction cap avoidance measures, which represent legally dubious strategies in service of poor policy. Reductions in itemized deductionItemized deductions allow individuals to subtract designated expenses from their taxable income and can be claimed in lieu of the standard deduction. Itemized deductions include those for state and local taxes, charitable contributions, and mortgage interest. An estimated 13.7 percent of filers itemized in 2019, most being high-income taxpayers. s, including the SALT deduction cap, help pay down rate reductions, so a policy of restoring the uncapped deduction for high-income taxpayers who continue to benefit from the lower rates doubles down on the benefits for a select group of taxpayers.
The forthcoming IRS guidance and regulations should be considered welcome news. While existing statutes, case law, and regulations are fairly clear on this matter, states have muddied the waters. Formal IRS guidance will help ensure that taxpayers do not rely on legally dubious state-endorsed strategies which could result in penalties and increased liability.
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