The Trump Administration recently passed a comprehensive tax reform package, which includes restrictions on state and local tax (“SALT”) deductions from federal income returns.1 For the fiscal year 2017, the Internal Revenue Code permits deductions for state, local, and foreign taxes relating to income and property taxes.2 Proponents argue that restriction of the deduction will provide the federal government with revenue that is otherwise lost to wealthy claimants.3 Opponents argue that restriction of the deduction will impose double taxation in all states collecting high taxes and will unduly burden their taxpayers compared to states with lower taxes.4 It is unlikely that state governments will be able to timely readjust their tax rates to reduce the effects of double taxation on their residents. As such, corporate and individual taxpayers will maneuver to exploit other tax deductions. However, the Internal Revenue Service (“IRS”) and state auditors will be pressured to collect more revenue to support their respective government apparatuses and will more closely scrutinize deduction claims. Thus, the elimination of the SALT deduction could signal a rise in tax litigation as agencies challenge these deductions claims.
Proponents might argue that the value of the SALT tax deductions is exaggerated. Admittedly, a narrow set of taxpayers claim the deduction. The SALT deduction has been consistently available since the first federal income taxes were collected under the Revenue Act of 1913.5 Today, only one-third of U.S. taxpayers claim a SALT deduction.6 Generally, higher-income taxpayers claim the deduction more frequently than lower-income taxpayers; taxpayers with incomes exceeding $100,000 claimed 75% of the aggregate dollar amount of SALT deductions in 2014.7 In contrast, that same year saw only 10% of taxpayers with incomes less than $50,000 claiming the SALT deduction.8 While higher-income taxpayers are more likely to take a SALT deduction, the federal individual Alternative Minimum Tax (“AMT”) limits the benefit for many wealthy claimants.9 The AMT is a parallel tax system that applies to certain classes of taxpayers who must calculate their gross income on both the standard income tax system and the AMT system and pay the greater amount.10 The AMT system does not permit SALT deductions, so the benefit of the deductions to wealthy taxpayers is not overly broad.11 While not every taxpayer is able to make use of SALT deductions, a wider class of taxpayers can still benefit from them. State and local governments use tax revenues to invest in locally tailored social services, such as education and local infrastructure.12 Lower-income and other taxpayers can also vote in state elections and referendums to influence state tax and allocation policies.13 Given this context, the SALT tax deduction is very crucial to public services and private tax burdens.
Congress’ passage of the recent tax bill restricting SALT deduction may lead taxpayers to suffer double taxation during the long response time state governments will likely take in moving to reduce state tax burdens on residents. State legislatures may suffer gridlock because so many competing interests and constituents rely on different social services funded from a finite treasury. Outside of a taxing crisis, states already suffer immense inertia in making an annual budget. For instance, Illinois took two years to approve a budget before the formal Trump Administration tax proposal.14 In deliberating on how to reduce taxes to ease the burden of double taxation on state residents, interest groups likely will clash over whose benefits to cut and by how much. Suburban families might urge legislators to maintain state grants to school districts while farming communities may oppose the reduction of agricultural subsidies.
Given the possibility of these extended political stalemates, taxpayers will have to seek their own solutions to curb their double taxation burdens. Taxpayers could relocate to states with favorable tax rates. However, lower-income individuals likely do not have the means to move. Aside from lacking time and money, they might face other obligations, such as family they want to stay close to and occupations tied to their current locations. Corporate taxpayers might not be able to freely relocate due to a range of business costs.15 Their goodwill and appeal to customers could be tied to the fact that they are local enterprises, and many firms may be unable to complete complex bureaucratic exit strategies, such as filing for incorporation or acquiring property. As such, many taxpayers will have to contend with their double taxation burdens with clever tax planning.
Taxpayers could use other sources of federal and state tax deductions, like assuming debts and mortgages or buying more depreciable assets than they would normally purchase. The Trump tax bill does retain many deductions, including mortgage interest and charitable donation benefits.16 Aside from a potential rise in business failures and bankruptcies, a more deleterious effect regards an increase in scrutiny by tax authorities of corporate and individual deduction claims. In a nation with reduced federal and state taxes, political leaders will bring pressuring agencies to collect more revenue to maintain government operations. Therefore, the IRS and state auditors could begin to more frequently audit tax deductions and become more willing to pursue contentious and continuous litigation against taxpayers in order to meet their revenue goals.
Tax authorities have scrutinized lawful deductions before. In early 2017, it was reported that the IRS started requiring mortgage lenders to provide more information on homeowners’ loans in order to determine if a mortgage deduction was credible.17 Once tax authorities begin denying deductions, a certain number of taxpayers will be willing to appeal them. Tax Court filings frequently see settlements soon after, but settlements might not be as common.18 Each side will face too much risk to concede or settle out of court; auditors must return concrete revenue to their demanding government administrators facing electoral pressures while taxpayers will face undue burdens under both federal and state taxes. This dynamic will continue until state legislatures readjust their tax rates, but even then, there will be some taxpayers more burdened by the loss of the SALT deduction and double taxation than others.
Many states appear to depend on the SALT deduction in order to collect higher state taxes and have more control over public services. The restriction on SALT deductions may impose burdensome double taxation on residents. In the aftermath, individual and corporate taxpayers may scramble to exploit deductions to alleviate this burden, which may lead the IRS and state officials to more openly and zealously challenge claims in order to maintain revenue. Thus, the restriction of SALT deductions could result in more taxation in the short-term for taxpayers and more litigation with the IRS and other auditors.
Julie Hirschfeld Davis & Alan Rappeport, Trump Proposes the Most Sweeping Tax Overhaul in Decades, N.Y. Times (Sept. 27, 2017), https://www.nytimes.com/2017/09/27/us/politics/trump-tax-cut-plan-middle-class-deficit.html. ↩
See 26 U.S.C. § 164(a) (2014). ↩
See Patricia Cohen, State and Local Tax Deductions: An Item Blurring Party Lines, N.Y. Times (Apr. 27, 2017), https://www.nytimes.com/2017/04/27/business/economy/state-local-income-tax-deduction.html. ↩
See Frank Sammartino, Repeal of the State and Local Tax Deduction, Urban-Brookings Tax Policy Center (Mar. 6, 2017), https://www.urban.org/research/publication/repeal-state-and-local-tax-deduction. ↩
See Jared Walczak, The State and Local Tax Deduction: A Primer, Tax Foundation (Mar. 15, 2017), https://taxfoundation.org/state-and-local-tax-deduction-primer/. ↩
See Nicole Kaeding, Eliminating the SALT Deduction Under “Big Six” Tax Plan, Tax Foundation (Sept. 27, 2017), https://taxfoundation.org/eliminating-salt-deduction-big-six-tax-plan/. ↩
See Sammartino, supra note 4. ↩
See id. ↩
See id. ↩
See id. ↩
See id. ↩
See Tax Policy Center Briefing Book State (and Local) Taxes, Urban-Brookings Tax Policy Center (2016), http://www.taxpolicycenter.org/briefing-book/how-does-deduction-state-and-local-taxes-work. ↩
See Eric Coffill & Robert Merten III, Blazing A Trail For More Local Taxes By Ballot Initiative, Law360 (Sept. 7, 2017, 1:08 PM), https://www.law360.com/articles/961383/blazing-a-trail-for-more-local-taxes-by-ballot-initiative. ↩
See John O’Conner, Illinois Has A State Budget, But No School Funding, Chicago Sun-Times (July 6, 2017, 6:16 PM), https://chicago.suntimes.com/politics/illinois-has-state-budget-but-no-school-funding-plan/. ↩
See Caron Beesley, The Legal Steps Involved in Moving Your Business to a New State – FAQs Answered, SBA Blogs: Managing a Business (Sept. 20, 2016), https://www.sba.gov/blogs/legal-steps-involved-moving-your-business-new-state-faqs-answered. ↩
See Davis, supra note 1. ↩
See Kenneth R. Harney, IRS May Be Stepping Up Scrutiny of Mortgage Deductions, Chi. Trib. (Feb. 15, 2017), http://www.chicagotribune.com/classified/realestate/ct-re-0219-kenneth-harney-20170215-column.html. ↩
See Kelly Phillips Erb, Taxpayer Advocate Reports On Top 10 Most Litigated Tax Issues, Forbes (Jan. 15, 2015), https://www.forbes.com/sites/kellyphillipserb/2015/01/15/taxpayer-advocate-reports-on-top-10-most-litigated-tax-issues/#834180548e6a. ↩
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