Though the Tax Cuts and Jobs Act (TCJA) was only signed into law at the end of last year, the historic changes to the federal tax code are already benefiting individuals and businesses. Because of TCJA reforms, the overwhelming majority of taxpayers will see a reduction in their federal tax liability, and pro-growth reforms have spurred business investment and raised business optimism to record levels. Aside from simply lowering rates and doubling the standard deduction, the law has made tax filing more efficient by streamlining tax credits and deductions.
One of the more consequential reforms of the tax law is the new $10,000 cap on the state and local tax (SALT) deduction, which was previously uncapped. The uncapped SALT deduction allowed individuals to write off taxes that are paid at the state and local level from their federal income tax liability, effectively subsidizing high-tax states. In response, many states have explored, and some have even enacted, convoluted strategies to preserve the full SALT deduction for high-income residents to flout the tax reform bill.
While New York and New Jersey passed their SALT workaround gimmicks back in April, last week Connecticut joined the fray by passing their own gimmick. Senate Bill 11, which was championed by Governor Malloy, unanimously cleared the Senate and easily passed the House in a vote late Wednesday night. The legislation makes notable changes that could impact many taxpayers and small businesses in the state. Lawmakers seem to view their work as the answer to the federal tax law, yet a series of serious questions linger about the legality of the bill’s approach and possible harmful economic consequences associated with it.
First, SB 11 gives taxpayers the option to make “donations” to a “community support organization” - a government entity created specifically to circumvent federal tax law - in exchange for a credit on property taxes, which remain deductible under federal law. This is a questionable strategy that could soon be invalidated by guidance from the Internal Revenue Service, since the “donations” are received by a government entity to finance public services, which looks an awful lot like a tax.
The scenario would go something along these lines: a taxpayer makes a voluntary charitable donation to an entity created by the local government that carries out near-identical functions of local government that would have otherwise been financed through normal taxes. The “charity” might pay a portion of teacher, police, or government salaries, purchase equipment, or subsidize employee benefit programs. A donation to the “charity” would grant the individual a matching property tax credit and allow them to claim a charitable deduction on their federal income tax return instead of counting towards their limited SALT deduction.
There are serious flaws in this scheme, the obvious being that the charitable contribution is nothing close to “charitable,” and looks more like a creative tax payment. Further, the Internal Revenue Service (IRS) does not permit a deduction if a taxpayer has received something of value from a charitable contribution. Since taxpayers are getting a matching dollar-for-dollar property tax credit for their donation, a clear financial benefit, it is possible that the contribution may be nondeductible. The IRS has yet to rule on the legality of the tax deductibility of donations made through such a scheme, but many observers expect them to shut it down with clear guidance to the contrary.
The second questionable component is the establishment of a new structure for taxation of pass-through income derived from businesses headquartered in the state. This plan is just as creative as the government-sponsored charity, and nearly as problematic.
Pass-through income is ordinarily taxed not at the business level but at the individual level, after it has “passed through” the business to them. The new Connecticut law targets these types of businesses, such as partnerships, S-corporations and limited liability companies, with a new 6.99 percent entity-level tax on their net receipts. This tax would be joined with an individual income tax credit for employees which would offset the entity-level tax. This maneuver would theoretically prevent the SALT deduction cap from applying fully to individuals employed by pass-through businesses by shifting their income from a non-deductible, to deductible source.
While many other states have a similar tax on the books, none of them offer a tax credit, making Connecticut the first state to try such an plan. One specific area that should concern taxpayers is the impact this new scheme will have on employees who work in Connecticut, but live in a neighboring states like New York or New Jersey. Those employees face the threat of double-taxation on the same source of income, as they’d be forced to pay an entity-level tax in Connecticut, but would not be eligible to receive a corresponding credit in their home state.
Instead of concocting convoluted, questionably-legal ways to skirt the federal tax reform bill, lawmakers at the state and local level should embark on fundamental reforms that will benefit taxpayers and the fiscal health of their states for the long term. Whether these changes to Connecticut's tax code will stand up against legal challenges remains uncertain, but evidence shows rate reductions for businesses and individuals stand the test of time and lead to better outcomes for all.