State’s workarounds for federal taxes not simple
Bills that pass through the General Assembly unanimously tend to receive little attention, and so it was last month when the Legislature approved a sweeping measure to counteract the federal tax reform act that took effect with President Donald Trump’s signature in December.
Recall, the federal reform sticks Connecticut taxpayers with thousands, in some cases tens of thousands of dollars, in extra liability if they pay more than $10,000 in state income taxes and local property taxes.
The combined loss for the Connecticut economy is in the billions, although the federal reform could still lower many people’s taxes overall.
The new Connecticut law, which Gov. Dannel P. Malloy signed at the end of May, attempts to make taxpayers whole again in two ways. Combined, they still won’t make up for the hit to some taxpayers, but they make a dent — if the IRS approves them.
One measure gives cities and towns the power to create local, tax-free “community-supporting organizations” to finance municipal functions. Property owners who contribute to such a “charity” would receive credits on their town taxes and, if the ploy works, would be able to deduct the full amount they paid the town, as they do with all charitable donations, if they itemize.
The other measure creates a new $600 million business profits tax for all “pass-through” businesses that have more than one employee — partnerships and Type-S corporations. The state immediately refunds that money to the people who own the businesses, for no net change in tax collection. And the business owners can take a full deduction.
New York, New Jersey, California, Illinois and Rhode Island have enacted, or are in the process of enacting, various forms of workarounds, according to the National Conference of State Legislatures. Some are similar to Connecticut’s law.
Can it happen?
Will the new state tax laws work? The stakes are huge. In Connecticut, 41 percent of taxpayers itemize, and would lose an estimated $10.3 billion in deductions for state and local taxes, known as SALT, according to the state Department of Revenue Services.
The average state taxpayer who itemized paid $19,664 in state and local taxes in 2015, according to the Tax Policy Center, a nonprofit partnership of two Washington, D.C., think tanks.
That means an average loss of $3,500 for hundreds of thousands of households, and many in Fairfield County would see losses a lot higher than that as a result of the $10,000 federal cap on deductions for SALT.
Only New York state was higher, with an average of $22,169 in SALT for taxpayers who itemized.
The new state laws represent a noble effort to combat a misguided federal policy designed to punish high-cost states, almost all of which cast their electoral votes against
Trump in the 2016 election.
Some defenders of the federal tax reform say the people who lose the most in the cap on deductions are rich households who will benefit from lower overall federal taxes. Although that’s true, there are millions of middle-class American households caught in the crossfire, with high SALT payments and incomes too low to benefit from the federal tax cuts.
And they live disproportionately in blue states such as Connecticut, New Jersey, New York and California, which now suffer economic losses compared with other states.
Let’s look at the town charity idea here, and come back to the passthough business tax in a future column.
Towns wait anxiously
The measure allowing cities and towns to set up charitable foundations creates the biggest controversy, and by far the most confusion. It sounds complicated, and it is.
“We’re going to do everything we can to make sure that we give our taxpayers the break that they deserve,” said Fairfield First Selectman Mike Tetreau, a Democrat, who calls the federal tax reform “appalling.”
But Tetreau added, “The steps involved that the legislation has defined are at the moment too complicated and not clarified by the legislation, so that there are too many questions.”
For example, would towns create one foundation overall, or several, one each for, say, public works, schools and pensions? Would these community-supporting organizations have private boards? If so, how could they be forced to allocate money the way the towns saw fit?
Under the law, donations to these organizations would be irrevocable — so what would happen if disputes arose?
“We’re still evaluating whether this is an approach we’d want to take,” said Westport First Selectman Jim Marpe. “I want to make sure I don’t end up implementing something that is administratively difficult and ends up costing the town.
“Every one of my counterparts who’s in an affluent community is looking at this, has their director of finance and/or their town attorneys looking at these rules,” Marpe said.
Walks like a duck
Biggest of all questions is the specter of a ban by the IRS, which is exactly what the federal tax collection agency threatened on May 23. Lawyers aren’t talking about it, as many supporters of the new laws in Connecticut, New York and New Jersey say privately they expect the IRS to reject the charity idea.
In a separate note, which the Connecticut Conference of Municipalities conveyed to cities and towns, the IRS asserted that it, and not states, gets to decide what constitutes a charitable donation and what constitutes a tax. In other words, if it walks like a duck, the
feds will call it a duck.
Certainly the “splash of cold water” from the IRS put a pause on the idea, Marpe said.
Regardless of the ruling, local taxpayers won’t see any relief this year and probably won’t see any help next year. The state law requires towns to set up a system by Oct. 1 for the following fiscal year, starting July 1. Few if any town officials think they can pull off that feat by this Oct. 1, especially towns that have a representative town meeting, such as Fairfield, Greenwich and Westport.
State officials wouldn’t say whether they — along with New York and New Jersey — would file suits to protect the new laws in the likely event the IRS rejects them. The three states are already preparing a lawsuit, announced in January, that will charge the entire tax reform illegally discriminates against states that have an income tax.
The state Office of Policy and Management has not yet sent out any guidance on what cities and towns should do. And so the towns wait, but the pressure to act will be powerful.
In Fairfield, for example, the typical homeowner in a house valued at $550,000 pays just under $10,000 in property taxes, Tetreau said. That means whatever amount that homeowner pays in state income taxes is no longer deductible on federal taxes — a huge hit.