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.

Pilgrim's Pride, A Senator And Tax Complexity

The Democratic staff of the Senate Finance Committee published a report last month titled “How Tax Pros Make the Code Less Fair and Efficient: Several New Strategies and Solutions.”

I set it aside, because it was March, I am a tax CPA and I was, you know, working. I apparently did not have the time liberties of Congressional staffers. You know the type: those who do not have to go in when it snows. When I was younger I wanted one of those jobs. Heck, I still do.

There was a statement from Senator Wyden, the ranking Democrat senator from Oregon:

Those without access to fancy tax planning tools shouldn’t feel like the system is rigged against them. 

Sophisticated taxpayers are able to hire lawyers and accountants to take advantage of … dodges, but hearing about these loopholes make middle-class taxpayers want to pull their hair out.”

There is some interesting stuff in here, albeit it is quite out of my day-to-day practice. The inclusion of derivatives caught my eye, as that of course was the technique by which the presumptive Democratic presidential nominee transmuted $1,000 into $100,000 over the span of ten months once her husband became governor of Arkansas. It must have taken courage for the staffers to have included that one.

Problem is, of course, that tax advisors do not write the law.  

There are complex business transactions taking place all the time, with any number of moving parts. Sometimes those parts raise tax issues, and many times those issues are unresolved. A stable body of tax law allows both the IRS and the courts to fill in the blanks, allowing practitioners to know what the law intended, what certain words mean, whether those words retain their same meaning as one travels throughout the Code and whether the monster comes to life after one stitches together a tax transaction incorporating dozens if not hundreds of Code sections. And that is “IF” the tax Code remains stable, which is of course a joke.

Let’s take an example.

Pilgrim’s Pride is one of the largest chicken producers in the world. In the late 1990s it acquired almost $100 million in preferred stock from Southern States Cooperative. The deal went bad.  Southern gave Pilgrim an out: it would redeem the stock for approximately $20 million.

I would leap at a $20 million, but then again I am not a multinational corporation. There was a tax consideration … and it was gigantic.

You see, if Pilgrim sold then stock, it would have an $80 million capital loss. Realistically, current tax law would never allow it to use up that much loss. What did it do instead? Pilgrim abandoned the stock, meaning that it put it outside on the curb for big trash pick-up day.

Sound insane?

Well, the tax Code considered a redemption to be a “sale or exchange,” meaning that any loss would be capital loss. Abandoning the stock meant that there was no sale or exchange and thus no mandatory capital loss.

Pilgrim took its ordinary loss and the IRS took Pilgrim to Court.

Tax law was on Pilgrim’s side, however. Presaging the present era of law being whatever Oz says for the day, the IRS conscripted an unusual Code section – Section 1234A – to argue its position.

Section 1234A came into existence to address options and futures, more specifically a combination of options and futures called a straddle. . What options and futures have in common is that one is not buying an underlying asset but rather is buying a right to said underlying asset. A straddle involves both a sale and a purchase of that underlying asset, and you can be certain that the tax planners wanted one side to be capital (probably the gain) and the other side to be ordinary (probably the loss). Congress wanted both sides to be capital transactions (hence capital gains and losses) even though the underlying capital asset was never bought or sold – only the right to it was bought or sold.

This is not one of the easiest Code sections to work with, truthfully, but you get an idea of what Congress was after.

Reflect for a moment. Did Pilgrim have (A) a capital asset or (B) a right to a capital asset?

Pilgrim owned stock – the textbook example of a capital asset.

Still, what is stock but the right to participate in the profits and management of a company? The IRS argued that – when Pilgrim gave up its stock – it also gave up its rights to participate in the profits and management of Southern. Its relinquishment of these rights pulled the transaction into the ambit of Section 1234A.

You have to admit, there are some creative minds at the IRS. Still, it feels … wrong, doesn’t it? It is like saying that a sandwich and a right to a sandwich are the same thing. One you can eat and the other you cannot, and we instead are being wound in a string ball of legal verbiage.

The Tax Court agreed with the IRS.  Pilgrim appealed, of course. It had to; this was a $80 million issue. The Appeals Court has now overturned the Tax Court.

The Appeal Court’s reasoning?

A “right” is a claim to something one does not presently have. Pilgrim already owned all the rights it was ever going to have, which means that it could not have had a right as envisioned under Section 1234A.

The tax law changed after Pilgrim went into this transaction, by the way.

Do I blame the attorneys and accountants for arguing the issue? No, of course not. The fact that an Appeals Court agreed with Pilgrim means the tax advisors were right. The fact that the law was later changed means the IRS also had a point.

And none of the parties involved  – Pilgrim and its attorneys and accountants, the IRS , the Tax Court and the Appeals Court wrote the law, did they?

Although the way Congress works nowadays, they may have been the first ones to actually read the bill-become-law. There perhaps is the real disgrace.

Senator Baucus Revs Up Tax Reform Discussion

Today (November 21, 2013) Senator Baucus released the third in a series of staff discussions on tax reform. This discussion focuses on depreciation (also called “cost recovery”) and tax accounting methods.

Not the most exciting topics, and I will not miss Thursday Night Football reading up on them. Let’s review them quickly.

The Senator leads off with:

America today is using a bloated tax code that was built for businesses close to 30 years ago. The code is completely outdated and acting as a brake on economic growth.  More must be done to simplify tax rules, lessen the burden on small businesses and jumpstart job growth.”

I cannot disagree with him, but I am not optimistic about politicians – today, tomorrow – keeping their hands off any tax reform. Remember that Chief Justice Roberts deemed ObamaCare to be a “tax” – even though the White House itself did not present brief or argue it to be a tax. With that level of verbal schizophrenia, I would wager that any “reform” would last about as long as when the first politician needs to get reelected.

Baucus is proposing the following depreciation changes:

(1) Reduce the number of depreciation classes to four: three for short- to mid-term property and one for longer-lived assets. There would be only one permitted depreciation method.

a.     By longer-lived, think real estate, which Baucus proposes to depreciate over 43 years.

COMMENT: There goes the never-worked-in-the-real-world-crowd again. I have thirty years in this business, and I have never seen a proposed real estate investment analyzed over a 43-year recovery. Doesn’t happen, folks.

(2) Slow depreciation from double-declining balance to declining balance. Real estate would remain straight-line.

(3)  Allow expanded general asset accounting. This means that asset categories are pooled, and depreciation is calculated by…

a.     Starting with last year’s asset pool balance

b.     Increased by additions and improvements

c.      Decreased by proceeds from asset sales and dispositions

d.     And multiplying the result by a depreciation factor

(4)  Repeal like-kind exchanges.

COMMENT: Yipes.

(5) Repeal depreciation recapture for pooled assets.

COMMENT: Yay!

Treat all gain from disposition of pooled assets as ordinary income.

          COMMENT: Nay!

(6)  The maximum cost of mixed- use vehicles is capped at $45,000.

a.     That means that – if a car is used for both business and personal use – the maximum cost that can be depreciated is $45,000. That amount in turn is depreciated over 5 years.

b.     I am not overly surprised. There is still a lot of abuse – truly – in this area.

Then there are some tax accounting changes:

(7) Repeal expensing for research and development expenses. The default treatment will be to capitalize and depreciate over 5 years.

COMMENT: This cannot make business sense. You want to explain this proposal change to Apple, Samsung, Pfizer, or any number of research-intensive companies?

(8) Disallow the deduction for advertising. In its place, you would deduct one-half immediately and then amortize the balance over 5 years.

COMMENT:  This makes no sense to an accountant. I associate depreciation and amortization with assets that have use or value over more than one year. Advertising doesn’t make that cut. Does anyone talk about the commercials from last year’s Super Bowl, for example?

(9) Treat “qualified extraction expenditures” the same way as research and development.

COMMENT: Think fracking. The United States is increasingly moving to energy independence (Bakken Shale, for example), even under a hostile Administration. Do you think this change is going to help or hurt that effort?

(10)  Repeal percentage depletion.

COMMENT: Same comment as (9).

(11)  Make permanent Section 179 expensing.

a.     The maximum expensing would be set at $1,000,000, with the phase-out beginning at $2,000,000.

COMMENT: Frankly, it’s about time.

(12)  The Section 197 amortization period is increased from 15 to 20 years.

(13)  All business with less than $10 million in annual gross receipts can use the cash basis of accounting and not account for inventory.

          COMMENT: Wait for it...

(14)  If you are not described in (13) then you are on the accrual basis of accounting.

COMMENT: When the government talks about accrual basis, they means that they want you to pay taxes on your receivables before you actually collect them.

(15)  Businesses described in (13) do not have to suffer through the Section 263A uniform capitalization calculations.

        COMMENT: Good. 

(16)  LIFO is repealed.  

COMMENT: I do not particularly care for LIFO, but I acknowledge that major industries use it extensively, and it is considered GAAP when auditors render their auditors’ report. The government is not chasing this down because they had brilliant debates while in accounting theory class. They want the jack.

(17) The completed contract method of accounting (think contractors) is repealed, except for small construction contracts.

Overall, Baucus is trying to reduce corporate tax rates. At 35%, the United States has the dubious distinction of having the highest corporate tax rate in the world. There are consequences to having the highest rate, such as having less business.  To reduce rates, he has to raise money somewhere, and we see some of those sources above.

And remember folks: these are only proposals.