Tax Cuts and Jobs Act

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The Internal Revenue Service announced today that it will waive the estimated tax penalty for many taxpayers whose 2018 federal income tax withholding and estimated tax payments fell short of their total tax liability for the year. The IRS is generally waiving the penalty for any taxpayer who paid at least 85 percent of their total tax liability during the year through federal income tax withholding, quarterly estimated tax payments, or a combination of the two. The usual percentage threshold is 90 percent to avoid a penalty.

The penalty relief announced today is designed to help taxpayers who were unable to properly adjust their withholding and estimated tax payments to reflect an array of changes under the Tax Cuts and Jobs Act (TCJA), the tax reform law enacted in December 2017. “We realize there were many changes that affected people last year, and this penalty waiver will help taxpayers who inadvertently didn’t have enough tax withheld,” said IRS Commissioner Chuck Rettig. “We urge people to check their withholding again this year to make sure they are having the right amount of tax withheld for 2019.”

The updated federal tax withholding tables, released in early 2018, largely reflected the lower tax rates and the increased standard deduction brought about by the new law. This generally meant taxpayers had less tax withheld in 2018 and saw more in their paychecks. However, the withholding tables could not fully factor in other changes, such as the suspension of dependency exemptions and reduced itemized deductions. As a result, some taxpayers could have paid too little tax during the year if they did not submit a revised Form W-4 withholding form to their employer or increase their estimated tax payments. The IRS and partner groups conducted an extensive outreach and education campaign throughout 2018 to encourage taxpayers to do a “Paycheck Checkup” to avoid a situation where they had too much or too little tax withheld when they file their tax returns.

An estimated tax penalty typically applies when the tax return is filed if too little is paid during the year. Normally, the penalty would not apply for 2018 if tax payments during the year met one of the following tests:

  • The person’s tax payments were at least 90 percent of the tax liability for 2018; or
  • The person’s tax payments were at least 100 percent of the prior year’s tax liability, in this case from 2017. However, the 100 percent threshold is increased to 110 percent if a taxpayer’s adjusted gross income is more than $150,000, or $75,000 if married and filing a separate return.

The penalty relief announced today lowers the 90 percent threshold to 85 percent. This means that a taxpayer will not owe a penalty if they paid at least 85 percent of their total 2018 tax liability. If the taxpayer paid less than 85 percent, then they are not eligible for the waiver and the penalty will be calculated as it normally would be, using the 90 percent threshold. For further details, see Notice 2019-11, posted today on IRS.gov.

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Our colleague James W. Minorchio has written a client alert about recent Internal Revenue Service guidance that clarifies when meals or drinks will be allowed as a deductible business expenses following the changes made by the Tax Cuts and Jobs Act. The TCJA generally disallowed any deduction for expenses related to entertainment, amusement or recreation. But the law did not specifically address the deductibility of business meals or the food and beverage expenses incurred in connection with a sporting event, recreation or other entertainment. Now the IRS has issued transitional guidance in Notice 2018-76 that sets forth a clear test for determining whether a business expense for food and beverages is deductible. You can read the client alert here.

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Four states have filed suit in U.S. District Court for the Southern District of New York, challenging the constitutionality of the new $10,000 cap on the federal tax deduction for state and local taxes, or SALT, enacted as part of the federal Tax Cuts and Jobs Act in 2017. The lawsuit is the latest effort by states to invalidate the SALT cap. It follows legislative workarounds enacted by New York and New Jersey, granting taxpayers in those states credits against state taxes for making contributions to state-created funds. The Internal Revenue Service has for its part responded by warning taxpayers that the federal law controls the characterization of deductions for federal income tax purposes and that taxpayers who utilize the state law workarounds do so at their peril. While this latest effort to challenge the SALT cap places the legality of the provision before the courts, the long-term fate of the SALT cap is more likely to be decided by the political, rather than the judicial, process.

The SALT Cap

Enacted in 2017, the TCJA was touted as the most significant tax reform legislation in three decades. Among its provisions is a $10,000 annual limitation on the deduction for state and local tax, which includes state and local income taxes, local real estate taxes and state sales taxes. Previously, there was no monetary limitation for an individual taxpayer’s SALT deduction. The new limitation is more detrimental to individuals in high tax states, such as California and New York. The average SALT deduction in California was around $18,500, while the average deduction in New York was around $22,000. The SALT limitation imposed by the TCJA applies to taxable years beginning after Dec. 31, 2017, and before Jan. 1, 2026.

State Efforts to Work Around the SALT Cap

Some states are attempting to work around the SALT limitation using creative legislative solutions. Earlier this year, New York Gov. Andrew Cuomo signed into law a new state-operated charitable contribution fund to accept donations for the purposes of improving health care and public education in New York state. Taxpayers who itemize deductions may claim these charitable contributions as deductions on their federal and state tax returns. Any taxpayer making a donation may also claim a state tax credit equal to 85 percent of the donation amount for the tax year after the donation is made. Taxpayers may also make qualified contributions to certain not-for-profit organizations for specified purposes. The law also authorizes local governments and school districts to establish charitable gift reserve funds and to offer real property tax credits to incentivize contributions to these new local charitable funds.

New Jersey soon followed suit, with Gov. Phil Murphy signing into law a measure allowing municipalities, counties and school districts to establish charitable funds where taxpayers can donate in return for a property tax credit. In return for donations, taxpayers would receive credits on their property tax bill of up to 90 percent of the donation. Taxpayers would then be able to claim their donation as a charitable deduction on their federal income tax return.

Efforts to work around the SALT cap are also underway in California. The California Senate has passed a bill that would allow taxpayers a credit against their state income tax for contributions to the newly created California Excellence Fund. A similar bill is pending in the California Assembly.

IRS Warns Taxpayers Regarding Efforts to Bypass SALT Cap

Earlier this year, the Internal Revenue Service notified taxpayers that it will soon be issuing regulations addressing the deductibility of state and local tax payments for federal income tax purposes. At the same time, the IRS reminded taxpayers that federal law controls the characterization of payments for federal income tax purposes regardless of the characterization of the payments under state law. These forthcoming regulations will be targeted at the state-level work-arounds described above.

The IRS said that the regulations, to be issued in the near future, will help taxpayers understand the relationship between federal charitable contribution deductions and the new statutory limitation on the deduction of state and local taxes. The IRS also warned that it is continuing to monitor other state legislative proposals being considered to ensure that federal law controls the characterization of deductions for federal income tax filings.

Is the SALT Cap Unconstitutional?

The latest effort by the states to challenge the SALT cap is the lawsuit filed by states New York, New Jersey, Connecticut and Maryland. The suit names as defendants the Secretary of the Treasury, the Acting Commissioner of Internal Revenue, the Internal Revenue Service and the United States of America. The states allege that the SALT cap violates numerous provisions of the U.S. Constitution, including the 10th Amendment, the 16th Amendment and Article I, Section 8.

According to a press release issued by Gov. Cuomo, the SALT cap was enacted to target New York and similarly situated states, interferes with states’ rights to make their own fiscal decisions and will disproportionately harm taxpayers in these states. An analysis by the New York State Department of Taxation and Finance shows that the cap will increase New Yorkers’ federal taxes by $14.3 billion in 2018 alone and an additional $121 billion between 2019 and 2025. A press release issued by Connecticut Gov. Dannel Malloy similarly said that Connecticut taxpayers will lose an estimated $10.3 billion in SALT deductions in 2018 and see an increase in federal income tax liability of approximately $2.8 billion in 2018.

The states’ lawsuit challenging the SALT cap asserts three causes of action arising under the U.S. Constitution. The first alleges that by capping the amount of the SALT deduction, the federal government has impermissibly interfered with the states’ sovereign authority to determine their own fiscal authority, thereby violating the 10th Amendment. In their second cause of action, the states allege the federal government has exceeded its powers under the 16th Amendment by failing to provide for a deduction for all, or a significant portion of, state and local taxes. Finally, the states allege a violation of Article I, Section 8, which provides Congress with the “[p]ower to lay and collect Taxes, Duties, Imposts and Excises, to pay the Debts and provide for the common Defence and general Welfare of the United States.” Specifically, the states contend that the SALT cap interferes with their sovereign authority to determine their own taxation and fiscal policies by “coercing the Plaintiff States into lowering their taxes and cutting the services those taxes support.”

The U.S. Department of Justice is expected to vigorously defend the SALT cap as a legitimate exercise of the federal government’s taxing power. The Justice Department will no doubt point out that the newly enacted SALT cap was not specifically targeted at the four plaintiff-states; rather, the cap applies uniformly throughout all of the states, even though it may have disproportionate impact in states with high property taxes. In addition, SALT cap defenders will note that although state and local taxes have been deductible since the creation of the federal income tax code in 1913, Congress has many times modified the scope of the allowable SALT deduction, including in the Tax Reform Act of 1986 and, most recently, in 2005. Finally, the Justice Department will surely rely upon the federal government’s constitutionally imbued and well-settled powers to tax and spend as set forth in Article 1, Section 8 Constitution in defending the SALT limitation.

While a federal judge will ultimately have to decide whether the states’ lawsuit has merit, the long-term viability of the SALT deduction cap will likely be determined by the political process instead. The outcome of the November mid-term elections will dictate which political party controls Congress. If the Democrats succeed in wresting back control of the House, expect to see legislation introduced to undo much of the TCJA, including the SALT cap deduction. If, on the other hand, the Republicans maintain their current majority in the House, the SALT cap will likely remain on the books, with its fate to be eventually determined by the courts — most likely an appellate court and potentially the Supreme Court of the United States.

Reprinted with permission from Law360. (c) 2018 Portfolio Media. Further duplication without permission is prohibited. All rights reserved.

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The States of New York, Connecticut, Maryland, and New Jersey filed a federal court lawsuit this week challenging the constitutionality of the new $10,000 cap on the federal tax deduction for state and local taxes (SALT). The lawsuit, filed in the Southern District of New York, names as defendants the Secretary of the Treasury, the Acting Commissioner of Internal Revenue, the Internal Revenue Service, and the United States of America. The States allege that the SALT deduction cap, enacted as part of 2017 tax reform, violates numerous provisions of the United States Constitution, including the Tenth Amendment, the Sixteenth Amendment, and Article I, Section 8.

According to a press release issued by New York Governor Andrew M. Cuomo, the lawsuit argues that the new SALT cap was enacted to target New York and similarly situated states, that it interferes with states’ rights to make their own fiscal decisions, and that it will disproportionately harm taxpayers in these states. An analysis by the New York State Department of Taxation and Finance shows that the cap will increase New Yorkers’ federal taxes by $14.3 billion in 2018 alone, and an additional $121 billion between 2019 and 2025. A press release issued by Connecticut Governor Dannel P. Malloy similarly estimated that Connecticut taxpayers will lose an estimated $10.3 billion in SALT deductions in 2018, and will increase Connecticut taxpayers’ federal income tax liability by approximately $2.8 billion in 2018.

The SALT deduction cap has been one of the most controversial provisions of the 2017 tax reform legislation.  We previously wrote about efforts by some states, including New York and New Jersey, to pass laws providing for mechanisms to work around the cap. These “workarounds” would allow taxpayers to make payments to specified entities in exchange for a tax credit against state and local taxes owed.  In May, the IRS the Internal Revenue Service notified taxpayers that it would soon be issuing regulations addressing the deductibility of state and local tax payments for federal income tax purposes, and issued a not-so-subtle reminder that federal law controls the characterization of payments for federal income tax purposes regardless of the characterization of the payments under state law.

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Today the Internal Revenue Service notified taxpayers that it will soon be issuing regulations addressing the deductibility of state and local tax payments for federal income tax purposes. The IRS also reminded taxpayers that federal law controls the characterization of payments for federal income tax purposes regardless of the characterization of the payments under state law. These forthcoming regulations are targeted at efforts by some states, including New York and New Jersey, to pass laws providing for mechanisms to work around the newly-enacted federal cap on state and local deductions. These “workarounds” typically allow taxpayers to make payments to specified entities in exchange for a tax credit against state and local taxes owed.

The federal Tax Cuts and Jobs Act (TCJA) limited the amount of state and local taxes an individual can deduct in a calendar year to $10,000. The IRS said that the regulations, to be issued in the near future, will help taxpayers understand the relationship between federal charitable contribution deductions and the new statutory limitation on the deduction of state and local taxes. The IRS also warned that it is continuing to monitor other legislative proposals being considered to ensure that federal law controls the characterization of deductions for federal income tax filings. The limitation imposed by the TCJA applies to taxable years beginning after December 31, 2017, and before January 1, 2026.

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Our colleagues Stanley Barsky, Michael S. Bookbinder, and Eric J. Michaels have published an article for Law360 addressing provisions of the Tax Cuts and Jobs Act that significantly affect the federal income tax consequences of structures often used in domestic mergers and acquisitions. These are the pass-through provisions of Section 199A, provisions relating to treatment of carried interests, changes related to treatment of certain intellectual property, and imposition of tax (and withholding obligations) in connection with a foreign person’s sale of interests in a partnership that has effectively connected income. The act contains a number of ambiguities, which makes application uncertain, and we expect and hope for clarifying regulations to be issued and technical corrections to be enacted. Until then, taxpayers and their advisers must tread carefully, relying on legislative history and, in certain cases, pre-act authorities to determine the scope and application of these provisions. Their article is available here.

Our colleague Tiana R. Seymore has authored a client alert addressing several provisions in the Tax Cuts and Jobs Act which directly impact the workplace, including one that gives some employers a credit for providing paid family and medical leave if they meet specific requirements and another that eliminates certain tax deductions in sexual harassment and sexual abuse cases.  You can read Tiana’s alert here.

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