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Tax Planning Related to the State Tax Deduction Limitation

Jan 22, 2019

Every year in late December, I evaluate whether to pay my real estate taxes before December 31 or wait until the due date. In the past, this was strictly related to cash flow and accelerating deductions. This year, a new factor was involved: Under Public Law 115-97, or the Tax Cuts and Jobs Act of 2017 (TCJA), effective for the 2018 tax year, the state tax deduction is limited federally to $10,000 ($5,000 for individuals and those married filing separate). So, this year I also had to review my pay statement for state income tax withholding. This law was passed in 2017, but the provisions are effective for 2018-2025.

As wage earners, this is simple for my wife and me. However, the real challenges are for individuals who own entities taxed as S corporations and partnerships. The income is not taxed at the entity level but rather at the owner level. Many financial institutions are taxed as S corporations, so this has been a tax challenge for them for 2018.

Many East Coast states have been developing creative workarounds for their property taxes through the use of community nonprofit organizations, whereby the individual would receive a charitable deduction and the organization would pay the donor’s property taxes. Other states have set up state funds that residents can make contributions to and receive a state income tax credit for 85% of the amount. Needless to say, the IRS believes these strategies will not be effective to recharacterize the tax payment as a charitable contribution.

A couple of states have created an entity-level business tax on the income of flow-through entities. Connecticut’s law was passed in the middle of the year, and Wisconsin added its provision in the middle of December. The Wisconsin law applies to S corporations for 2018 and partnership entities for 2019. The theory is that the tax is paid by the entity and then is deductible in determining income to be reported to the shareholders on their K-1. For state tax purposes in Connecticut and Wisconsin, the income would then be exempt to the shareholder.

Wisconsin has always allowed S corporations to formally opt out and be taxed at 7.9% as a corporation. However, the entity would then be treated as an S corporation for federal purposes and a C corporation for Wisconsin purposes. The shareholder’s basis would not change for Wisconsin purposes, and distributions would be treated as dividends (taxed if the shareholder is a Wisconsin resident). This new provision would allow the payment of tax at the entity level at 7.9%, but basis and distributions would still be treated under the S-corporation rules.

Since Wisconsin passed this so late in the year, there is little guidance on the issue. The state, however, has clarified that the entity would need to pay tax by the unextended due date of the S corporation’s return and that estimates previously made by the shareholders could not be transferred by the shareholders to the entity. The shareholders would receive a refund when their individual tax return is filed. Thus, companies choosing to utilize this strategy would need to have the cash flow to play the taxes at the entity level.

If the entity has shareholders who are residents of other states, it is unclear how those states would treat the payments by the entity when determining the credit for taxes paid to other states. We believe that many states may treat them similarly to composite payments made by the entity.

Recent guidance by the IRS in Revenue Procedure 2019-12 creates some concern about how the IRS might evaluate these business entity taxes. Many individuals have interpreted this guidance as creating uncertainty about the IRS’s acceptance of these business entity taxes.

We expect to see more states create strategies to maximize the benefits of former state and local taxes for their residents. Isn’t it ironic that now states are trying to create tax schemes to avoid federal tax? One commentator even suggested that states may need to comply with tax shelter promotor regulations. On January 9, 2019, legislation was introduced in the House to overturn the state and local tax deduction limitation. It remains to be seen what, if any, traction that bill will gain.

Wipfli has a dedicated group of state tax professionals to help our clients evaluate their situations and determine the risks and benefits of these new tax strategies.