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Battle Royal Heats Up Between IRS and States

05.29.18 | SALT Chat

Digital or Analog? Mono or Stereo? I’ve never been much for format wars. In the classic 1961 release, “First Time! The Count Meets the Duke” you had your choice. If you bought the mono version, both bandleaders’ orchestras could be heard blaring equally out of both speakers. But if you bought the stereo release, Basie is blaring from the left and Ellington from the right. Even though the very first cut on the record is entitled “Battle Royal,” critics described the release as far from a battle of the bands and more like a mutual admiration society. Stereo or mono, pay no mind. Let’s just get to the music.

Yet since the enactment of the federal Tax Cuts and Jobs Act (TCJA) states have been fighting the format wars, attempting to repackage lost state and local tax deductions into charitable contributions and deductible business taxes. Who sounds better? In my opinion I would sooner go back to eight-tracks.

Right before the long holiday weekend, the IRS released IRS Newswire Issue Number (IR-2018-122), which addresses the release of IRS Notice 2018-54, “Guidance on Certain Payments Made in Exchange for State and Local Tax Credits.”  The stated purpose of the Notice is to inform:

… taxpayers that the Department of the Treasury (Treasury Department) and the Internal Revenue Service (IRS) intend to propose regulations addressing the federal income tax treatment of certain payments made by taxpayers for which taxpayers receive a credit against their state and local taxes.

The Notice goes on to state:

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.

And finally the Notice reminds us:

The proposed regulations will make clear that the requirements of the Internal Revenue Code, informed by substance-over-form principles, govern the federal income tax treatment of such transfers.

Yet the states have and continue to propose legislative constructs (some might say schemes) to preserve in some form, the state and local tax deduction. The IRS is warning us, embrace these constructs at our own risk. Will the IRS regulations, if they appear be valid or are these warning shots from the IRS a call for the states to back down? The Battle Royal is just beginning.

I will be monitoring developments, so if you have questions, contact me at WBerkowitz@BerdonLLP.com or your Berdon advisor.

Wayne Berkowitz, a tax partner and head of the State and Local Tax Group at Berdon LLP, New York Accountants, advises clients on the unique requirements of governments and municipalities across the nation.