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What One Must Know About the $10,000 Limit on Deducting State and Local Taxes

If you are you are finalizing tax returns for 2018 or doing tax planning for 2019 and later years, you probably recall the Internal Revenue Code (“Code”) provides for the itemized deduction from adjusted gross income of state and local real property, personal property, income, and in lieu of income taxes, sales taxes at the election of the taxpayer. Code Section 164, the deduction provision, has existed in a number of different forms dating back to the earliest days of the Federal income tax. Unusually, since January 1, 2018, and until December 31, 2025, however, Section 164 has provided that the itemized deduction for all these kinds of taxes is limited to $10,000 per year. Recent media reports state that the result generally has been increased 2018 Federal income taxation for wealthy families resident in high tax states. One should expect the circumstance to continue. In 2026 et seq., the $10,000 limit sunsets, unless Congress extends the limit.

During 2018, and to employ a simplified but generally accurate fact pattern, some high income tax states enacted tax laws allowing electing, resident taxpayers to make contributions to approved state or local governmental entities in lieu of paying state income taxes. In exchange for these contributions, electing taxpayers are allowed a credit reducing their state income taxes. For example, a state now allows a credit against its income tax of $.90 of eligible contribution per $1.00 of what otherwise would be greater state income taxes. The theory underlying the legislation is that a large enough number of enacting states’ taxpayers’ Federal income taxes would be decreased to make the increased state or local administrative burdens accompanying the state legislation worthwhile. Why decreased? The fact is that state and local governmental entities of all kinds qualify as “charities” under Code Section 501(c)(3). Moreover, Code Section 170 charitable income tax deduction limitations long in place most often will not come into play.

The reader should know that during July, 2019, New York, New Jersey and Connecticut filed a joint lawsuit in the Federal District Court for the Southern District of New York (Docket No. 1:19 CV 6642) against Secretary of the Treasury, Steven T. Mnuchin, and other named defendants, asserting that Treasury Decision 9864 (June 13, 2019), effective for contributions made from and after August 27, 2018, is having the unlawful effect of rendering ineffective 2018 state tax legislation like that described above. The Village of Scarsdale, New York, did the same in the same court also during July, 2019 (Docket No. 7: 19 CV 6654). In a nutshell, both lawsuits ask the Federal court to declare unlawful and enjoin the IRS from enforcing Treasury Regulations. We think professional tax attorney general observations about the lawsuits’ Federal tax reporting impact are worthwhile for visitors to our website.

Under Code Section 6662(a), tax penalties include a penalty equal to 20% of unreported income taxes, not only on account of negligence, but also on account of a substantial underpayment of tax which is defined as the greater of $5,000 or 10% of the total tax that should have been reported on the return — a variety of “no fault” penalty. However, Congress also enacted Section 6664(c)(1), which provides that no penalty is imposable if a taxpayer filed a tax return “in good faith” and with a “reasonable basis” for the tax return position thereon, and Section 6662(d), which provides that there is not an underpayment of tax on which to impose the 20% penalty to the extent the tax return treatment of the tax item at issue reflects either (i) the “substantial authority” behind the tax treatment or (ii) the return provides “adequate disclosure” of the facts and circumstances for the tax treatment and the taxpayer has a reasonable basis for the position. The most legitimately aggressive action for any taxpayer is to file a tax return reflecting a position against Treasury Regulations. In light of the subject regulations, “substantial authority” appears lacking.

It also seems to us the fact that several of the states enacting “work around” legislation are now in Federal court seeking declaratory judgments against the Treasury Regulations provides a reasonable basis for claiming a charitable income tax deduction for contributions to state or local government entities made in accordance with the particular state’s legislation. Concerning “adequate disclosure”, Treasury Regulation 1.6662-4(f) provides as follows:

Disclosure is adequate with respect to any item…or a position on a return … in the case of a position contrary to a regulation, disclosure must be made on Form 8275-R (Regulation Disclosure Statement).

Although an unusual outcome, filing Form 8275-R appears to us as the most sensible thing to do if one is going to claim a Federal income tax charitable deduction following a work around statute. Another sensible idea is giving serious thought to changing state tax residency this year or next. These general observations are a guide to our readers, not the rendering of legal advice. No two situations are likely to be objectively the same, and no two clients have the same sensibilities. The experienced attorneys at Herold Law, P.A., can be of service to you in evaluating your particular Federal, state and local tax posture. Please don’t hesitate to contact Robert S. Schwartz, Esq., at 908-647-1022, or contact him at [email protected] for further information or assistance.