IRS to Issue Guidance Clarifying Viability of SALT Deduction Cap Workarounds

May 23, 2018

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 tax (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 tax to obtain an offsetting tax credit against its employees’ individual income tax 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 deductions, 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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A 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.

Itemized 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.