Deducting State And Local Taxes On Your Individual Return

You probably already know about the change in the tax law for deducting state and local taxes on your personal return.

It used to be that you could itemize and deduct your state and local income taxes, as well as the real estate taxes on your house, without limitation.  Mind you, other restrictions may have kicked-in (such as the alternative minimum tax), but chances are you received some tax benefit from the deduction.

Then the Tax Cuts and Jobs Act put a $10,000 limit on the state income/local income/property tax itemized deduction.

Say for example that the taxes on your house are $5 grand and your state income taxes are $8 grand. The total is $13 grand, but the most you can deduct is $10 grand. The last $3 grand is wasted.

This is probably not problem if you live in Nevada, Texas or Florida, but it is likely a big problem if you live in California, New York, New Jersey or Connecticut.

There have been efforts in the House of Representatives to address this matter. One bill would temporarily raise the cap to $20,000 for married taxpayers before repealing the cap altogether for two years, for example.

The tax dollars involved are staggering. Even raising the top federal to 39.6% (where it was before the tax law change) to offset some of the bill’s cost still reduces federal tax receipts by over $500 billion over the next decade.

There are also political issues: The Urban-Brookings Tax Policy Center ranked the 435 Congressional districts on the percentage of households claiming the SALT (that is, state and local tax) deduction in 2016. Nineteen of the top 20 districts are controlled by Democrats. You can pretty much guess how this will split down party lines.

Then the you have the class issues: approximately two-thirds of the benefit from repealing the SALT cap would go to households with annual incomes over $200,000. Granted, these are the people who pay the taxes to begin with, but the point nonetheless makes for a tough sell.

And irrespective of what the House does, the Senate has already said they will not consider any such bill.

Let’s go over what wiggle room remains in this area. For purposes of our discussion, let’s separate state and local property taxes from state and local income taxes.

Property Taxes

The important thing to remember about the $10,000 limitation is that it addresses your personal taxes, such as your primary residence, your vacation home, property taxes on your car and so on.

Distinguish that from business-related property taxes.

If you are self-employed, have rental real estate, a farm or so on, those property taxes are considered related to that business activity. So what? That means they attach to that activity and are included wherever that activity is reported on your tax return. Rental real estate, for example, is reported on Schedule E. The real estate taxes are reported with the rental activity on Schedule E, not as itemized deductions on Schedule A. The $10,000 cap applies only to the taxes reported as itemized deductions on your Schedule A.

Let me immediately cut off a planning “idea.” Forget having the business/rental/farm pay the taxes on your residence. This will not work. Why? Because those taxes do not belong to the business/rental/farm, and merely paying them from the business/rental/farm bank account does not make them a business/rental/farm expense.

         

State and Local Income Taxes

State and local income taxes do not follow the property tax rule. Let’s say you have a rental in Connecticut. You pay income taxes to Connecticut. Reasoning from the property tax rule, you anticipate that the Connecticut income taxes would be reported along with the real estate taxes when you report the rental activity on your Schedule E.

You would be wrong.

Why?

Whereas the income taxes are imposed on a Connecticut activity, they are assessed on you as an individual. Connecticut does not see that rental activity as an “tax entity” separate from you. No, it sees you. With that as context, state and local income tax on activities reported on your individual tax return are assessed on you personally. This makes them personal income taxes, and personal income taxes are deducted as itemized deductions on Schedule A.

It gets more complicated when the income is reported on a Schedule K-1 from a “passthrough” entity. The classic passthrough entities include a partnership, LLC or S corporation. The point of the passthrough is that the entity (generally) does not pay tax itself. Rather, it “passes through” its income to its owners, who include those numbers with their personal income on their individual income tax returns.

What do you think: are state and local income taxes paid by the passthrough entity personal taxes to you (meaning itemized deductions) or do they attach to the activity and reported with the activity (meaning not itemized deductions)?

Unfortunately, we are back (in most cases) to the general rule: the taxes are assessed on you, making the taxes personal and therefore deductible only as an itemized deduction.

This creates a most unfavorable difference between a corporation that pays its own tax (referred to as a “C” corporation) and one that passes through its income to its shareholders (referred to as an “S” corporation).

The C corporation will be able to deduct its state and local income taxes until the cows come home, but the S corporation will be limited to $10,000 per shareholder.

Depending on the size of the numbers, that might be sufficient grounds to revoke an S corporation election and instead file and pay taxes as a C corporation.

Is it fair? As we have noted before on this blog, what does fair have to do with it?

We ran into a comparable situation a few years ago with an S corporation client. It had three shareholders, and their individual state and local tax deduction was routinely disallowed by the alternative minimum tax.  This meant that there was zero tax benefit to any state and local taxes paid, and the company varied between being routinely profitable and routinely very profitable. The SALT tax deduction was a big deal.

We contacted Georgia, as the client had sizeable jobs in Georgia, and we asked whether they could – for Georgia purposes – file as a C corporation even though they filed their federal return as an S corporation. Georgia was taken aback, as we were the first or among the first to present them with this issue.

Why did we do this?

Because a C corporation pays its own tax, meaning that the Georgia taxes could be deducted on the federal S corporation return. We could sidestep that nasty itemized deduction issue, at least with Georgia.

Might the IRS have challenged our treatment of the Georgia taxes?

Sure, they can challenge anything. It was our professional opinion, however, that we had a very strong argument. Who knows: maybe CTG would even appear in the tax literature and seminar circuit.  While flattering, this would have been a bad result for us, as the client would not have appreciated visible tax controversy. We would have won the battle and lost the war.

However, the technique is out there and other states are paying attention, given the new $10,000 itemized deduction limitation. Connecticut, for example, has recently allowed its passthroughs to use a variation of the technique we used with Georgia.

I suspect many more states will wind up doing the same.