New York and New Jersey have enacted legislation in response to certain aspects of the Tax Cuts and Jobs Act of 2017 (“TCJA”) including the $10,000 federal deduction limitation for state and local taxes.
The legislation contains provisions that provide mechanisms for taxpayers to circumvent the $10,000 limitation. Subsequently, the Internal Revenue Service issued Notice 2018-54 indicating that the IRS intends to issue proposed regulations addressing the federal income tax treatment of payments made by taxpayers to state controlled funds in exchange for credits against state and local taxpayers in order to circumvent the $10,000 limitation.
New York Governor Andrew Cuomo included the following in a statement released in response to the IRS Notice: “Make no mistake. We have been, and will continue to, fight against this economic missile with every fiber of our being.
The IRS should not be used as a political weapon and I urge this administration to stop its partisan assault on New Yorkers and instead work with us to deliver real, lasting relief for hardworking families.” New Jersey Attorney General Gurbir S. Grewal said in a May 24th letter to the IRS Commissioner David J. Kautter “Should the IRS and Treasury Department continue down this path, New Jersey will have no choice but to challenge the new rule in court.” The validity of some of the provisions in the recently passed New York and New Jersey laws may not be known for some time and may ultimately be decided by the courts.
New York Governor Andrew Cuomo recently signed the fiscal year 2019 budget (“legislation”), making New York the first state to enact legislation in reaction to the TCJA. The highlights of the legislation, including the optional employer compensation expense tax (“ECET”) and the establishment of two new state-operated charitable funds, address the negative impact that the TCJA has on many New York taxpayers as a result of the $10,000 federal deduction limitation for state and local taxes.
For corporate taxpayers, the legislation decouples from federal treatment of repatriated foreign income under IRC §951, essentially categorizing this income as “exempt CFC income,” thereby excluding it from New York State Corporate Tax.
Provisions in Response to the TCJA
The New York Department of Taxation and Finance issued a report that estimates that the federal limitation of the state and local tax deduction will cost New York taxpayers $14.3 billion per year and will negatively impact the competiveness of the state’s economy over the long term. Several of the provisions discussed in this section were added to the budget after issuance of this report to provide potential workarounds for circumventing the $10,000 federal limitation on the state and local tax deduction.
Optional Employer Compensation Expense Program (“ECEP”)
This program will allow employers to voluntarily opt in to a new structure provided by the ECEP that will impose a payroll tax that is applied to the annual payroll expense for “covered employees,” defined as employees who receive more than $40,000 in annual wages. The applicable rate will be phased in over three years beginning on January 1, 2019, starting at 1.5%, increasing to 3% in 2020, and fully phased in at 5% in 2021. It is applied to payroll expenses in excess of $40,000 for each covered employee. The employer can make the annual election to participate in the program by December 1st of each calendar year, to take effect for the wages paid beginning January 1st of the following year. The payroll tax is due on the same date the employer is required to submit withholding payments.
This program provides a mechanism that allows the individual’s lost federal state income tax deduction to be shifted to the employer, who is allowed this deduction under business income tax rules. The current New York personal income tax system will remain in place, and covered employees will be allowed a credit against their New York State personal income tax for a portion of the employer’s payroll expense tax paid with respect to the wages of the employee. In 2019, the credit is calculated by multiplying the covered employee’s wages in excess of $40,000 by 1.5% (the 2019 payroll expense tax rate), and then multiplying by 1, minus a fraction that is calculated by dividing the New York State personal income tax imposed on the employee before application of any credits by the employee’s state taxable income.
Assume that Company X has three employees, and elects into the ECEP for tax year 2019:
Employee A has total 2019 annual salary of $39,000, with $0 in excess of $40,000
Employee B has total 2019 annual salary of $100,000, with $60,000 in excess of $40,000
Employee C has total 2019 annual salary of $500,000, with $460,000 in excess of $40,000
For Company X, the ECET that is paid and deductible is as follows:
Total in excess of $40,000 (per covered employee) X 1.5% (2019 tax rate) $520,000 X 1.5% = $7,800
Each employee will take a credit on his New York Personal Income Tax Return using the formula above.
State-Operated Charitable Funds
The legislation provides ways for New York individual taxpayers to make charitable contributions and subsequently be allowed to claim a credit against their New York State personal income tax liability in the amount of 85% of their contributions to the funds made in the immediately preceding calendar year. Taxpayers are eligible to claim this credit for tax years beginning after 2018.
The contributions must be made to the state-operated “charitable gifts trust fund” which was created by the legislation, consisting of two accounts: (1) a “health charitable account” and (2) an “elementary and secondary education charitable account.” These funds were designed to accept donations for purposes of improving health care and education in the State of New York. It should be noted that based on current statute, no credit or deduction will be allowed for New York City purposes.
In addition to the contributions to the “charitable gifts trust fund,” a credit is also allowed for 85% of the contributions made to Health Research, Inc., the State University of New York Impact Foundation and the Research Foundation of the City University of New York.
The state has also put in place another mechanism to mitigate the impact of the $10,000 federal limitation on the state and local tax deduction. The legislation allows local governments to create charitable funds that benefit their localities and offer, in return, property tax credits up to 95% of contributions.
Under the new law, individuals claiming the standard deduction for federal purposes will be able to elect to claim itemized deductions for New York.
Foreign Source/Repatriated Foreign Income
For corporate taxpayers, the legislation also addresses components of the TCJA as it relates to foreign source income and repatriated foreign income. The legislation, for New York State and New York City Corporation Franchise Tax purposes, make the following provisions:
- The TCJA imposed a one-time tax on the accumulated earnings and profits of certain foreign corporations under IRC §965, also known as the “transition tax.” For federal purposes, the accumulated E&P is taxed as Subpart F income but is also subject to a deduction under IRC §965(c). The legislation defines the E&P from foreign corporations that are not included in the taxpayer’s Article 9-A combined return as “exempt CFC income,” and this is therefore not taxable in New York State or New York City.
- Taxpayers are required to add back the deduction under IRC §965(c), since the E&P subject to the transition tax is considered “exempt CFC income.” However, there is no change to the existing provision allowing direct or indirect attribution of the taxpayer’s interest deductions related to the exempt income, or the election which would allow the taxpayer to reduce its total exempt income by 40% as an alternative to expense attribution.
- The legislation provides relief from underpayment of estimated taxes related to any interest expense attribution related to this “exempt CFC income.” This exemption applies to taxable years beginning on or after January 1, 2017 and before January 1, 2018.
- The TCJA, by adding IRC §250, created a deduction of 37.5%, decreased to 21.875% for tax years after 2025, on total Foreign Derived Intangible Income (FDII) received by a U.S. corporation in a taxable year. FDII is the U.S. Corporation’s portion of its intangible income, calculated based on a formula, derived from serving foreign markets. The legislation disallows this deduction and requires taxpayers to add back the deduction in calculating its New York State and New York City taxable income.
- IRC §250 also provides a 50% deduction, decreased to 37.5% for tax years after 2025, on total Global Intangible Low-Taxed Income (GILTI) received by a U.S. corporation, as well as any deemed dividend under IRC §78 that is attributable to GILTI. The legislation is silent as to its treatment of GILTI. Therefore, the deduction provided under IRC §250 is included in calculating New York State and City taxable income. The legislation does, however, clarify that the subtraction modification taken for deemed dividends under IRC §78 should be limited to amounts not already deducted for Federal purposes under IRC §250.
The legislation also makes some notable provisions, unrelated to TCJA, highlighted below.
Personal Income Tax
- The legislation will codify long-standing administrative practice regarding the statutory residence test and provide guidance on the application of the State’s and City’s day count policies. A part-year resident will be required to include all days spent in New York, regardless of whether an individual was domiciled in New York State or New York City for any part of the taxable year when considering the 183-day period for statutory residency. This is effective for all open tax years.
- The statute of limitations for assessing tax on amended returns is extended up to one year after the return is filed. This provision is designed to prevent taxpayers from amending tax returns to claim refunds just before the statute of limitations expires in hopes of avoiding potential additional taxes.
- The legislation extends the existing New York City personal income tax rate to 2021.
Sales and Use Tax
A provision provides sales tax liability relief for minority partners of a limited partnership or members of a limited liability company. Under prior law, these persons were potentially held liable for any unpaid taxes of these business entities, even though they were not responsible individuals under a duty to act.
Under the new law, if the partner or member was not under a duty to act on sales tax requirements, and held less than a 50% share of profit and loss in the business, he/she would be liable only for the sales tax multiplied by their pro rata share of the ownership of the partnership or LLC.
New Jersey Governor Phil Murphy signed Bill A-3499 into law allowing municipalities and local governments to establish charitable funds. Taxpayers who contribute to these charitable funds would receive a tax credit of up to 90% of the donation towards their property tax bills. Taxpayers would, in turn, claim the payment as a charitable contribution on their federal return. The law is slated to take effect 60 days from Friday, May 4th.
INTERNAL REVENUE SERVICE
The Internal Revenue Service (IRS) announced, in Notice 2018-54, that they will issue proposed regulations to address the federal income tax treatment of these payments made to state-controlled funds that are efforts to work around the $10,000 limitation on the federal deduction for individual state and local taxes.
While the details of the proposed regulations are not yet known, it is clear that substance will prevail over form when governing the federal income tax treatment of these charitable contributions. The IRS, for the time being, seems to be addressing the treatment of charitable contributions only, and does not reference the Employer Compensation Expense Program (“ECEP”), discussed above, although Treasury has indicated that additional rules may be set forth for those types of work-arounds as well
As New York and New Jersey are the first states to pass legislation addressing the TCJA, there is uncertainty on the workarounds for the cap on the state and local tax deduction. The Department of Treasury warns “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 payments for federal income tax purposes.” It is also unclear whether the Internal Revenue Service will allow New York’s employer payroll expense deduction and its related credit available to individual taxpayers under the ECEP. The proposed regulations that will be issued may answer some questions, but final answers may need to be given by the courts.
Please contact your Mazars USA LLP professional for additional information.