TaxProf Blog

Editor: Paul L. Caron, Dean
Pepperdine University School of Law

Wednesday, January 2, 2019

Will New Jersey’s State & Local Tax Deduction Workaround Work?

Philadelphia Inquirer, Will New Jersey’s 'IRS-Proof’ Workaround to Deduct High State and Local Taxes Work?:

One of the more controversial parts of the 2017 federal Tax Cuts and Jobs Act had to with state and local taxes. The bill, which became law a year ago, limits the annual deduction, which applies to property, sales and other similar taxes paid by individuals, to $10,000.

For people living in states with a lower tax burden this was not such a big deal. But for residents in states where taxes are higher — such as New Jersey — it’s a very big deal. According to one study, the average New Jersey resident pays in excess of $10,000 in state and local taxes a year. That’s compared with about $4,100 for both Pennsylvania and Delaware residents.

The tax also affects many small-business owners in New Jersey, particularly ones that file “pass-through” returns, like S-corporations, limited liability companies, and partnerships. That’s because their business income flows down to their personal returns, where the $10,000 deduction limitation for state and local taxes applies. Many lawmakers in the state believe that this was an unnecessary burden on these business owners.

So last week, those lawmakers took a big step that they believe will help small-business owners skirt the federal tax limitation by unanimously passing the “Pass-Through Business Alternative Income Tax Act.” The proposed legislation, which would be retroactive to Jan. 1, 2018, is expected to affect about 260,000 individuals and families in the state that report around $23 billion in pass-through income from their businesses. ...

In effect, the legislation is nothing more than a bit of wordsmithing. Instead of calling local taxes an income tax applied to individuals, it’s now renaming it to an “elective entity-level tax” and thereby giving it business expense status. That way, a small-business owner can fully deduct these tax payments on their corporate returns — which is fully allowed under federal law — before any net income flows down to their individual return.

The big question is whether this type of local legislation will fly with the IRS, given the agency’s rejection earlier this year of other proposed rules by states such as New Jersey that tried to redefine tax payments as charitable contributions. Some experts aren’t convinced that the strategy would work.

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So the "social justice”advocates have now come up with a bit of open trickery to help wealthy people in wealthy states. And people wonder why Trump won.

Posted by: Mike Livingston | Jan 2, 2019 4:26:11 AM

So much for wanting to close tax "loopholes" for the rich. Here we have Blue states wanting to create new loopholes.

Posted by: ruralcounsel | Jan 2, 2019 6:26:33 AM

I am not sure what the point of the prior postings is.

The New Jersey legislation, as I understand it, is attempting to create horizontal equity between businesses organized as C corporations and businesses organized as S corporations or partnerships with respect to state and local taxes on business income. I agree that the predominant beneficiaries of the legislation are higher income. Why creating this kind of horizontal equity is "open trickery" or a "loophole", however, escapes me. Nor it is clear to me how it advances the ball to call the New Jersey legislature "social justice advocates" when it tries to level the playing field between different modes of business organization.

Posted by: Ted Seto | Jan 2, 2019 7:21:28 AM

Ted Seto is correct. Horizontal and vertical equity provisions can appear to be loopholes if you ignore equity concerns. For example, the mortgage interest deduction promotes equity between homeowners with mortgages and homeowners without mortgages. The latter have a higher ability to pay.

Posted by: AMTbuff | Jan 2, 2019 12:05:28 PM

What Ted says seems right to me assuming the legislation is referring to business property rather than residences. Is that the case?

Posted by: Mike Petrik | Jan 2, 2019 3:05:09 PM

" assuming the legislation is referring to business property rather than residences"

There's no real difference for sole proprietors and pass thru entities. They still get the deduction - regardless what form it shows up on.

Posted by: ruralcounsel | Jan 7, 2019 3:44:06 AM