Federal Tax Treatment of Proposed NY Inflation Refunds

12/9/24 news release

Per a December 9, 2024 story at the New York State website, Governor Hochul has proposed "sending 8.6 million New Yorkers an Inflation Refund Check as first proposal of 2025 State of the State."

The rationale is that inflation increased the price of taxable goods and services on which sales tax was charged. So, the state collected more sales tax than it would have without inflation's affect on prices. Governor Hochul proposes giving "everyday New Yorkers":

   $500 for families making under $300,000

   $300 for individuals making under $150,000

Big question ... Will these "tax refunds" be subject to federal income taxes (must the recipients include them in their federal income tax)?

I think the answer is yes.

Income is broadly defined at IRC §61 and case law as being derived from any source and something that is an accession to wealth. In Notice 2023-56 suggested how the tax law applies to various payments received from a state and sought public comments for the IRS's final guidance (which has not yet been issued).

In Notice 2023-56, the IRS noted that the name given to a payment is not controlling but instead, the substance of the payment arrangement controls. If a tax "refund" is limited to how much tax the individual actually paid, the payment is likely to be a non-taxable tax refund (taxable though if the taxpayer claimed a deduction (tax benefit) for the tax later refunded).

The NY proposal is the same for everyone at a specified income level or marital status. It appears to have no relation to how much sales tax the recipient actually paid.

Notice 2023-56 also explains the general welfare exclusion where payments are made based on need. This also won't apply to the NY "refunds" as the income levels at which they can be issued is well beyond "needs" and the median income level.

Is there anyway to avoid the federal tax hit so that 100% of the refunds can stay in New York?  Well, they could be changed to be, for example, 10% of the actual sales tax paid. But people won't have these records. It could be achieved by temporarily lowering the sales tax rate to give buyers back some portion of sales tax by paying less today than they otherwise would. They could use the additional sales tax collected to provide funding for services available to low-income individuals.

I think they could significantly lower the income level for these payments, so that they are truly only provided to those in need making them excludable under the general welfare exclusion.

What do you think?

7th Anniversary of Tax Cuts and Jobs Act Enactment

P.L. 115-97, An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018, commonly known as the Tax Cuts and Jobs Act (TCJA), was signed into law on December 22, 2017. It had many changes including significant ones such as a permanent change from a progressive corporate rate structure of 15% to 35% to a flat 21% on a permanent basis. Most of the 160 million individual filers got a tax reduction but on a temporary basis for 2018 through 2025 due to a drop in where tax rates begin, almost doubling of the standard deduction and a $2,000 rather than $1,000 child tax credit.

Most of the individual tax cuts and tax increases were only put into the TCJA for 2018 through 2025. That is, the TCJA had expiration dates for many tax cuts and tax increases (such as the $10,000 SALT cap and disallowance of a deduction for home equity interest). It also had built-in tax increases with significant ones affecting businesses already in effect such and capitalizing R&D rather than expensing it and phasedown of 100% bonus depreciation.

I have a list of the temporary provisions as well as the tax increases that have already started and ones to start after 2025 at the end of this post.  I also have track changes for some of the TCJA changes from this January 2018 blog post.

While we are hearing a lot about extending the individual and estate tax cuts, there are non-TCJA provisions that expire at the end of 2025 including the Work Opportunity Tax Credit, New Markets Tax Credit and enhanced Premium Tax Credit (PTC). For a list of all expiring provisions, see this JCT report issued every January - JCX-1-24 (1/11/24).

Will the expiring provisions all just be renewed including those that expired a few years ago (R&D, §163(j) formula, bonus depreciation at 100%)? Is this the best mix of tax changes for an effective tax law?  For example, the disallowance of miscellaneous itemized deduction subject to the 2%-of-AGI floor is contrary to the operation of an income tax as these include expenditures to produce taxable income such as hobby expenses (up to hobby income), investment expenses and unreimbursed employee business expenses. There are easily over 50 tax expenditures that don't belong in the tax law that could be modified or eliminated to enable for permanent lower rates and an even higher child tax credit for low-to-middle income taxpayers. These include the mortgage interest deduction, exclusion for employer-provided health insurance and other fringe benefits (these could be reduced based on income level and subject to a cap), the higher standard deduction for the elderly or tie it to income, and more.

Will we see a discussion of what changes are best for economic growth? Items other than the expiring or expired provisions?  We'll see.

What do you think?

List of expiring or expired provisions: (tax increases built into TCJA as enacted 12/22/17):

•        International Provisions:

•        tyba 12/31/25, deduction for GILTI reduced from 50% (10.5% US tax rate) to 37.5% (13.125% US tax rate)

•        tyba 12/31/25, FDII deduction reduced to 21.875% (16.406% effective tax rate on FDII) compared to 37.5% deduction (13.125% effective tax rate on FDII) for 2018 through 2025.

•        tyba 12/31/25, BEAT rate increases from 10% to 12.5%

•        BEAT = Base Erosion and Anti-Abuse Tax (§59A and Form 8991)

•        Business Provisions:

•        §174 expensing converted to capitalization and amortization for tyba 12/31/21.

•        100% bonus depreciation started to phasedown starting in 2023 (80%), continuing to no bonus in 2027.

•        §163(j) business interest expense became less taxpayer favorable starting for tyba 12/31/21. Prior to that time, add back depreciation, amortization and depreciation to adjusted taxable income (ATI) which is the limitation.  Today, don’t add it back making ATI smaller.

•        §199A Qualified Business Income Deduction ends after 2025.

•        §274(o) – no deduction for meals provided at convenience of employer including for operating facility for the meals starting for amounts paid or incurred after 12/31/25.

•        Individual Provisions:

•        It is a long list including of tax cuts and tax increases. Temporary tax cuts included the higher standard deduction, $2,000 rather than $1,000 child tax credit, lowered brackets and a few others. Temporary tax increases included disallowance of interest on home equity debt, no deduction for miscellaneous itemized deduction subject to the 2% of AGI threshold, the $10,000 SALT cap and others. See complete list from the JCT here.

Reforming Treatment of Business Start-up Expenditures

Today, once a business starts carrying on business (when it is no longer getting ready, but is instead ready to serve customers), it can start amortizing its start-up expenditures as defined under IRC Section 195 over 15 years. If the total is $55,000 or less, up to $5,000 can be expensed immediately and this amount phases down as the aggregate expenditures range from $50,001 to $55,000.

S. 5204, Tax Relief for New Businesses Act, would increase the expensing amount from $5,000 to $50,000 and the phaseout point to $150,000. The bill sponsors note that the average small business spends about $40,000 to get their businesses from getting ready to carrying on.

Those with over these amounts today or per S. 5204, are amortizing expenses over 15 years. Meanwhile, we allow use of the cash method of accounting by most businesses, and have Section 179 expensing of over $1 million. Why not just allow the small business to expense up to the Section 179 amount along with other eligible section 179 property? This sounds like simpler and would truly help small businesses. That is why amortize something over 15 years when Section 179 expensing is over $1 million?

This proposal is in a list of proposals from several years back from the AICPA Tax Division on modernizing the tax law for small businesses. I hope that upcoming tax reform will not just extend expiring or expired TCJA items but also take a look at reforms that would help businesses and make sense given other provisions in the law.

I've offered additional tax reforms to help small businesses in this blog. One of my favorites (beyond what is in the AICPA paper which I'm pleased to say I was able to assemble with other volunteers and staff when I was chairing the AICPA Tax Executive Committee), is allowing co-owners of a new business to elect to be a Qualified Joint Venture something which today is only available to spouses (where both file identical Schedule Cs). This would be very helpful for a start-up run by two or more people because while they are getting started, they don't have to deal with setting up an LLC or filing a partnership return - which is a lot of work when unfortunately, they might not survive. After a few years, they would be required to shift to a partnership or C or S corporation.

I'm sure many people have ideas to truly help simplify tax rules for small businesses. 

What do you think?

Modernizing California's Tax System for Equity and Logic

Excerpt: California Tax Expenditure Report

California's tax system has a few longstanding weaknesses including volatility in its income tax and a sales tax system designed for the early 20th century economy. Also, like the federal government and other states, California has special deductions and exclusions in its income tax system that provide oversized breaks (subsidies) and upside down benefits to high income taxpayers. Upside down refers to a situation where if the government wanted to, for example, use funds to help taxpayers pay for something like housing or health insurance, they likely would provide higher payments to lower income individuals than higher income ones on the premise that the lower income individuals need greater assistance. However, when the assistance is provided in the income tax without any phaseout as income increases, higher income taxpayers get a bigger subsidy because their higher bracket provides a greater tax savings.

I had two short articles published this month that describe equity and logic issues with California's tax system and offer a few suggestions for improvement.

1. State tax law opportunities to address inequality - published in the Joint Venture Silicon Valley blog (11/6/24).

2. Apple Settlement Shows Why California Needs a Sales Tax Overhaul - published in Bloomberg's Tax Insights & Commentary (11/14/24)

I have been writing about these topics since I started this blog back in 2007 and they are not getting better.  Encouraging broader understanding of the issues, possible improvements and how they can benefit many individuals as well as the economy, can hopefully encourage people to ask lawmakers to work on legislative improvements.

What do you think?

Improving the American Opportunity Tax Credit

Excerpt from Pub 970

In May 2024 I had the opportunity to participate in the California Lawyers Association Tax Section's DC Delegation. Participants identify a tax rule in need of reform and draft a paper explaining why change is needed and offer proposals for that reform.

My May paper was on modifying and clarifying the American Opportunity Tax Credit (AOTC) which offers up to $10,000 of tax credit (subsidy) to most families for a child (or themselves) in the first four years of college ($2,500 maximum credit for year for up to four years).

The phaseout income levels for the credit are quite high so at least 80% of families qualify.

But there is a bit of unneeded confusion and complexity in the provision including exactly how the "first four years of college" are determined. An example on the IRS website makes it sound like you can select which of the four years of college count which seems out of sync with Code Section 25A (Q&A 16).  But in sync if we are only required to ask if the student has reached "senior" status at the university. This basic issue should not be confusing, but is.

The IRS has an Interactive Tax Assistant tool on its website which can help but I found it might cause some users to give up such as asking if your spouse has an ITIN after answering "single" to the question about whether you are married.

There is also some complex planning possible if a student receives a scholarship, including a Pell Grant, that is partially taxable. One fix to help Pell Grant recipients has been proposed a few times but not enacted is to not require a Pell Grant recipient to reduce AOTC-eligible expenses by the amount of the grant.

For more background and my recommendations for both legislative and administrative improvements, see "Modify and Clarify the American Opportunity Tax Credit," Tax Notes Federal, 9/26/24.

What do you think?