In a May 23 notice, the IRS announced it will issue proposed regulations addressing the deductibility of state and local tax payments for federal income tax purposes.
The notice comes in the wake of legislative proposals in several states, including Connecticut, to minimize the impact of the cap on state and local tax deductions imposed by last year’s federal tax reform.
The new federal tax law limits the amount of state and local taxes individuals and businesses that pay their taxes through the personal income tax (pass-through entities) can deduct in a calendar year to $10,000.
Among other things, Connecticut’s proposal, SB 11 (now Public Act No. 18-49), creates a new 6.99% state income tax on pass-through entities, such as S corporations.
This new “business entity tax,” like the business taxes paid by non-pass-through entities, e.g., C-corporations, would be paid at the business level rather than the personal level and, as a result, be fully deductible from federal income taxes as a business expense.
The new tax would then be offset by a personal income tax credit.
SB 11 also enables municipalities to allow eligible taxpayers to make voluntary payments to municipally approved charitable organizations, or “community supporting organizations,” in exchange for a tax credit against their state and local taxes.
Those payments could then be deducted as charitable deductions, which are not capped, from federal income taxes.
Connecticut’s Proposal in Jeopardy
The IRS notice explicitly targets that component of Connecticut’s and other state’s tax proposals:
“The aim of these proposals is to allow taxpayers to characterize such transfers [payments to community supporting organizations] as fully deductible charitable contributions for federal income tax purposes, while using the same transfers to satisfy state or local tax liabilities,” the notice states.
“Despite these state efforts to circumvent the new statutory limitation on state and local tax deductions, taxpayers should be mindful that federal law controls the proper characterization of payment for federal income tax purposes.
“The proposed regulations will make clear that the requirements of the Internal Revenue Code, informed by substance-over-form principles, govern the federal income tax treatment of such transfers.”
However, the IRS also said that it intends to look at state legislative proposals beyond those involving charitable deductions, which means that Connecticut’s new business entity tax plan could also be in the agency’s crosshairs.
According to a May 23 Connecticut Mirror report, the IRS announcement “makes it highly unlikely that Connecticut’s new tax plan will ever be fully implemented.”