Will New Jersey’s 'IRS-proof’ workaround to deduct high state and local taxes work?

One of the more controversial parts of the 2017 federal Tax Cuts and Jobs Act had to with state and local taxes. The bill, which became law a year ago, limits the annual deduction, which applies to property, sales and other similar taxes paid by individuals, to $10,000.

For people living in states with a lower tax burden this was not such a big deal. But for residents in states where taxes are higher — such as New Jersey — it’s a very big deal. According to one study, the average New Jersey resident pays in excess of $10,000 in state and local taxes a year. That’s compared with about $4,100 for both Pennsylvania and Delaware residents.

The tax also affects many small-business owners in New Jersey, particularly ones that file “pass-through” returns, like S-corporations, limited liability companies, and partnerships. That’s because their business income flows down to their personal returns, where the $10,000 deduction limitation for state and local taxes applies. Many lawmakers in the state believe that this was an unnecessary burden on these business owners.

So last week, those lawmakers took a big step that they believe will help small-business owners skirt the federal tax limitation by unanimously passing the “Pass-Through Business Alternative Income Tax Act.” The proposed legislation, which would be retroactive to Jan. 1, 2018, is expected to affect about 260,000 individuals and families in the state that report around $23 billion in pass-through income from their businesses.

To be sure, the state General Assembly still has to sign off on the bill, and even if it does become a law, it could still be rejected by the Internal Revenue Service.

“We’re going ‘Back to the Future’ with an IRS-proof solution,” State Sen. Paul Sarlo (D., Bergen), chairman of the Senate Budget and Appropriations Committee and the prime sponsor of the legislation, told the Burlington County Times. “It will return to a tax system that was in place for decades. This legislation doesn’t solve the whole problem created by a federal tax law that targets New Jersey by sharply curtailing the federal deduction for state and local taxes. But we are going to do everything we can to help New Jersey taxpayers."

In effect, the legislation is nothing more than a bit of wordsmithing. Instead of calling local taxes an income tax applied to individuals, it’s now renaming it to an “elective entity-level tax” and thereby giving it business expense status. That way, a small-business owner can fully deduct these tax payments on their corporate returns — which is fully allowed under federal law — before any net income flows down to their individual return.

The big question is whether this type of local legislation will fly with the IRS, given the agency’s rejection earlier this year of other proposed rules by states such as New Jersey that tried to redefine tax payments as charitable contributions. Some experts aren’t convinced that the strategy would work.

“What these efforts lack in legal merit, they make up for in political positioning,“ Jared Walczak, a senior policy analyst for the Tax Foundation, a tax policy nonprofit wrote last August. “Litigation is likely, though probably futile, given the authority the government has in such matters. In the wake of this new guidance, any state wishing to continue its fight will be placing political performance theater over the interests of the taxpayers who have to foot the bill.”

The takeaway for New Jersey small business owners? If the bill does become state law, go ahead and take advantage of the deduction. Just don’t spend your savings right away.

— Gene Marks is a certified public accountant and the owner of the Marks Group, a 10-member technology and financial management consulting firm in Bala Cynwyd.