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.

A BallPark Tax

I am a general tax practitioner, but even within that I set limits. There are certain types of work that I won’t do, if I do not do enough of it to (a) keep the technical issues somewhat fresh in my mind and (b) warrant the time it would require to remain current.

Staying current is a necessity. The tax landscape is littered with landmines.

For example, did you know there is a tax to pay for Nationals Park, the home to the Washington Nationals baseball team?

I am not talking about a sales tax or a fee when you buy a ticket to the game.

No, I mean that you have to file a return and pay yet another tax.

That strikes me as cra-cra.

At least the tax excludes business with gross receipts of less than $5 million sourced to the District of Columbia.

That should protect virtually all if not all of my clients. I might have a contractor go over, depending on where their jobs are located in any given year.

Except ….

Let’s go to the word “source.”

Chances are you think of “source” as actually being there. You have an office or a storefront in the District. You send in a construction work crew from Missouri. Maybe you send in a delivery truck from Maryland or Virginia.

I can work with that.

I am reading that the District now says that “source” includes revenues from services delivered to customers in the District, irrespective where the services are actually performed.

Huh?

What does that mean?

If I structure a business transaction for someone in D.C., am I expected to file and pay that ballpark tax? I am nowhere near D.C. I should at least get a courtesy tour of the stadium. And a free hot dog. And pretzel.

COMMENT: My case is a bad example. I have never invoiced a single client $5 million in my career. If I had, I might now be the Retired Cincinnati Tax Guy.

I can better understand the concept when discussing tangible property. I can see it being packaged and shipped; I can slip a barcode on it. There is some tie to reality.

The concept begins to slip when discussing services. What if the company has offices in multiple cities?  What if I make telephone calls and send e-mails to different locations? What if a key company person I am working with in turn works remotely? What if the Browns go to the Super Bowl?

The game de jour with state (and District) taxation is creative dismemberment of the definition of nexus.

Nexus means that one has sufficient ties to and connection with a state (or District) to allow the state (or District) to impose its taxation. New York cannot tax you just because you watched an episode of Friends. For many years it meant that one had a location there. If not a location, then perhaps one had an employee there, or kept inventory, or maybe sent trucks into the state for deliveries. There was something – or someone – tangible which served as the hook to drag one within the state’s power to tax.

That definition doesn’t work in an economy with Netflix, however.

The Wayfair decision changed the definition. Nexus now means that one has sales into the state exceeding a certain dollar threshold.

While that definition works with Netflix, it can lead to absurd results in other contexts. For example, I recently purchased a watch from Denmark. Let’s say that enough people in Kentucky like and purchase the same or a similar watch. Technically, that means the Danish company would have a Kentucky tax filing requirement, barring some miraculous escape under a treaty or the like.

What do you think the odds are that a chartered accountant in Denmark would have a clue that Kentucky expects him/her to file a Kentucky tax return?

Let’s go back to what D.C. did. They took nexus. They redefined nexus to mean sales into the District.  They redefined it again to include the sale of services provided by an out-of-District service provider.

This, folks, is bad tax law.

And a tax accident waiting to happen.

New York And State Donation Programs

You may have read that the new tax law will limit your itemized tax deduction beginning this year (2018).

This is of no concern to you if you do not itemize deductions on your personal return.

If you do itemize, then this might be a concern.

Here is the calculation:

        *  state income taxes plus

        *  local income taxes plus

        *  real estate taxes plus

        *  personal property taxes

There is a spiff in there if you live in a state without an income tax, but let’s skip that for now.

You have a sum. You next compare that sum to $10,000, and

… you take the smaller number. That is the maximum you can deduct.

Folks, if you live in New Jersey odds are that real estate taxes on anything is going to be at least $10 grand. That leaves you with no room to deduct New Jersey income taxes. You have maxed.

Same for New York, Connecticut, California and other high tax states.

Governor Cuomo said the new tax law would “destroy” New York.

Stepping around the abuse of the language, New York did put out an idea – two, in fact:

·       Establish a charitable fund to which one could make payments in lieu of state income taxes. When preparing one’s individual tax return, one could treat contributions to that fund as state taxes paid. To make this plausible, New York would not make the ratio one-to-one. For example, if you paid $100 to the charitable fund, your state tax credit might be $90. Surely no one would then argue that you had magically converted your taxes into a charitable deduction. The only one on the short end is the IRS, but hey … New York.

·      Have employers pay a new payroll tax on employee compensation, replacing employee withholding on that compensation.  Of course, to get this to work the employee would probably have to reduce his/her pay, as the employer is not going to keep his/her salary the same and pay this new tax.

Other states put out ideas, by the way. New York was not alone.

I somewhat like the second idea. I do however see the issue with subsequent raises (a smaller base means a smaller raise), possibly reduced social security benefits, possible employer reluctance to hire, and the psychological punch of taking a cut in pay. Ouch.

The first idea however has a sad ending.

You see, many states for many years thought that there were good causes that they were willing to subsidize.

·       Indiana has the School Scholarship Credit. You donate to a scholarship-granting charity and Indiana gives you a tax credit equal to 50% of the donation on your personal return.

·       South Carolina has something similar (the Exceptional SC), but the state tax credit is 100%.

New York and its cohorts saw these and said “What is the difference between what Indiana or South Carolina is doing and what we are proposing?”

Well, for one thing money is actually going to a charitable cause, but let’s continue.

This past summer the IRS pointed out the obvious: there was no charity under New York’s plan., The person making the “donation” was simultaneously receiving a tax benefit. That is hardly the hallmark of a charitable contribution.

Wait, wait, New York said. We are not giving him/her a dollar-for-dollar credit, so …..

Fine, said the IRS. Here is what you do. Subtract the credit from the “donation.” We will allow the difference as a deductible contribution.

In fact, continued the IRS, if the spread is 15% or less, we will spot you the full donation. You do not have to reduce the deduction for the amount you get back. We can be lenient.

So what have New York and cohorts done to Indiana, to South Carolina and other states with similar programs?

You got it: they have blown up their donation programs.

Way to go.

Why did the IRS not pursue this issue before?

Well, before it did not matter whether one considered the donation to be a tax or a deductible contribution. Both were deductible as itemized deductions. There was no vig for the IRS to chase.

This changed when deductible taxes were limited to $10,000. Now there was vig.

There are about 30 states with programs like Indiana and South Carolina, so do not be surprised if this reaches back to you.

Ohio Reforms Its Local Income Taxation

I remember having to quickly ramp-up on local taxes after moving to Cincinnati. I grew up in Florida, which has no state or local individual income taxes. We moved here from Georgia, which has a state but no local income taxes. I did not realize at the time that I was moving to a region which has approximately 80% or more of all the local income taxes in the nation – Ohio, Indiana, Pennsylvania and Kentucky.

The Kentucky local individual taxes are – for the most part – occupational taxes. If you do not work in one of those counties or cities, you generally do not have to worry about it. I live in Kentucky, for example, but I pay no Kentucky local income taxes. I do not work in Kentucky.

Indiana has county taxes, but they are filed with the state individual income tax return. Think of it as a “piggy-back” tax.

Ohio had to be different. For one thing, Ohio cities tax their residents, meaning that – if you live within the city – you have yet one more tax return to file. It doesn’t matter whether you work there (in contrast to Kentucky), and in many cases you have to file a return whether you owe tax or not. You might not owe tax, for example, if the city allows (at least some) credit for the local taxes paid to the city where you work (for example, if you live in a suburb but work downtown).

Add to this that each city has local autonomy to determine its taxable base, within the limits of Ohio law. One city could tax supplemental retirement benefits (SERPs), while another would not. One city could allow you to carry over a net operating loss (NOL) to future years, while another city would not.  Even if the city allowed an NOL, your city might allow a carryover of five years, while another would allow only three.

Even for a tax pro, it is a pain.

On December 19, 2014 the Governor signed a bill that promises to bring some standardization to the wild west of Ohio local income taxation. It is called the Ohio Municipal Income Tax Reform Act, and it will be effective for tax years beginning on and after January 1, 2016. The delay was intentional, as tax forms may need to be redesigned and instructions updated. A tax bill signed in December does not leave much time for that. 

Let’s go over the high points:

(1) The calculation of local taxable income will begin with federal adjusted gross income. The adjustments to federal AGI have been significantly standardized and include, for example, interest, dividends and capital gains.

NOTE: There are two cities in Ohio that start with Ohio adjusted gross income (from the Ohio state income tax return). Those two do not have to change to the new law. One of them is in Cincinnati and rhymes with Indian Hill. The effect for residents of Indian Hill is to tax their interest, dividends and capital gains. 

(2) Partnerships and LLCs will be taxed at the entity level only. Partners and members will subtract this income (as an adjustment under (1) above) when calculating their city tax.

That leaves Subchapter S shareholders to discuss.

(3) Subchapter S corporations will also be taxed at the entity level.

In addition, S shareholders may also continue to be taxed at the individual level if they live within 119 selected municipalities.

OBSERVATION: Obviously not as good as the rule for partnerships and LLCs. Why the difference? Who knows.          

(4) Losses from a passthrough entity (that is, a partnership, LLC, Subchapter S or (unlikely) a trust) may offset self-employment, rental, royalty and farming income. The reverse is also true.

(5) Net losses from (4) however cannot offset wages and salaries.

(6) Employee business expenses (that is, “Form 2106” expenses) will be deductible to the extent deducted for federal purposes.

(7) Ohio cities will have to limit their consideration of “domicile” to 25 common law-type tests. The cities are not permitted to add to these 25 tests.

NOTE: This is the “snowbird” test. I have had cities tell me they do not recognize snowbirds. A house there means you are taxed there, whether you spend much time at the house or not.

(8) An employee or sole proprietor is allowed to go into and out of a city for up to 20 days without triggering withholding for that city’s income tax.

NOTE: The previous threshold was 12 days. Notice that we are discussing withholding taxes only. A city may still contact a business for business income taxes if it spots business vans and work trucks stopping within the city.

(9) Pensions are not taxable.

NOTE: SERPs are considered to be wages, not pensions. SERPS are deferred compensation plans, usually funded exclusively by the employer. The tax reporting for a SERP is done on Form W-2 - the same reporting as one's wages or salary - so the cities take the position that SERPs are wages and not pension income.

(10)        Returns will be due (for a calendar year taxpayer) on April 15.

(11)        The returns will be automatically extended if a federal extension is requested.

(12)        Estimated individual income taxes will be required only if the estimated tax due is $200 or more.

(13)        Any tax due (before withholdings or estimates) of $10 or less will be reduced to zero.

NOTE: You still have to file the tax return, though.

(14)        Any interest due will charged at the federal rate plus 5% (Ohio’s rate is federal plus 3%).

(15)        Net operating losses are standardized.

a.     Beginning January 1, 2017 all cities will allow a uniform 5-year carryover (with a phase-in).

b.     Earlier NOLs will be permitted as allowed by pre-change city law.

c.      City NOLs will be calculated using federal limitations such as passive activity, basis or at-risk limitations.

NOTE: This is a subtle but very significant change – in favor of the cities.

(16)        Certain administrative changes, such as requiring the cities to send out an assessment notice -clearly marked “ASSESSMENT” – before they can change your numbers on the city return.

The Ohio Society of CPAs was an outspoken advocate of these changes. I am  sympathetic to arguments the cities raised, but I am nonetheless thankful for some standardization. I prepare or review local returns. I have to bill for this, as this is my profession. I have routinely seen business clients with multiple local returns where the cumulative tax is a fraction of the professional fee to prepare the returns. I submit that a tax is unfair when the preparation fee routinely exceeds any tax so raised. Call it Hamilton's razor if you wish. 

By the way, I would apply the same razor to federal and state taxes. A corollary to the razor would require Congress to reduce its revenue estimates from any proposed tax by the compliance costs (that is, the professional fees) of complying with said proposed tax. I suspect we wouldn't see as much nonsense as we presently have in the tax Code.
 

Ohio Offers Two Tax Amnesties

As part of the 2012/2013 budget bill, Ohio has authorized a general amnesty for selected state taxes, including personal income, school district, sales and commercial activity taxes.

This is an attractive amnesty program, although it does have one significant drawback. Under the program Ohio will abate all penalties and one-half the interest. Taxes eligible for the amnesty must have been due and payable as of May 1, 2011. This means that a 2010 individual income tax will be eligible (as it was due April 15, 2011), but a May 2011 sales tax return would not (as it was due June 23, 2011). In addition, you cannot have been previously contacted by Ohio.

Ohio expects full payment when you file these tax returns. Remember – this is a revenue raiser for the state.

The significant drawback? The general amnesty window is very brief: from May 1 to June 15, 2012.

There is a separate use tax amnesty that runs from October 1, 2011 to May 1, 2013.

Note: Use tax applies to purchases of taxable products or taxable services where the seller did not collect the Ohio sales tax. The use tax applies both to individuals and businesses. The use tax is the cousin to the Ohio sales tax. It serves to prohibit one from avoiding Ohio sales tax by purchasing items from another state (free of sales tax) and then bringing them into Ohio.

If one pays all use tax due on or after January 1, 2009, Ohio will waive or abate use tax owed for prior periods. There is also a non-interest payment program available for businesses not previously registered for use tax, although this option requires an officer to personally guarantee the tax debt. On the plus side, Ohio will allow the business up to seven years to pay the back taxes. Once again, you cannot have been previously contacted by Ohio.