IRS Hits Back Against State Governments

The Internal Revenue Service (IRS) has taken a rigid stand against states searching for loopholes to bypass the new provisions. It has given a notice that the Treasury Department will clarify all deductibility of the local taxes and state taxes for federal use. This may not match up with what the states thought of in the first place.

Tax reforms

The problem stems from the fact that a new tax reform package was passed through the White House and Congress in the latter part of 2017. The discussion of measures got divided along party lines. Among the many controversial portions of the new package was the restriction of itemized deductions on local and also state taxes to $10,000. This move is seen by many high tax states as a politically motivated one. Those states in retaliation have searched for multiple possible responses to preserve those deductions. The idea was to circumvent the said federal law.

As per old laws, the taxes paid to local and state governments were usually eligible for non-restricted deduction for those entities who itemize and not take a standard deduction. To be specific, no restrictions existed on the property tax amount a person could claim as a deduction. A taxpayer could either select to take the amount of money they paid for local and state income taxes or take back the amount paid as sales tax for additional deduction. Initial efforts at tax reform actually wanted to eliminate such deductions. A compromise was reached where a provision was inserted to restrict total deduction to about $10,000. This was made to appease taxpayers in multiple states having more moderate tax burdens. The tax rates, however, continue to be steep in places like California and New York. State legislators then looked at all measures which may potentially come up with the alternative rationales so that the federal deductibility can be justified.

State responses

The states predictably responded in their own ways. They began to search for ways to re-characterize the state tax payments. The latter was subject to restrictions as perpetual charitable contributions. For example, New York state established a charitable fund run by the state which will accept donations. In return, a tax credit will be provided against the state tax bills. It can be surmised that federal authorities were not happy with such state moves. The IRS warned taxpayers to not make any moves to circumvent taxes pointing out that federal law is applicable for purposes of federal income tax.

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