The American Jobs Creation Act of 2004 permits taxpayers to deduct either their state and local income taxes or their state and local sales taxes as an itemized deduction for 2004 and 2005.
As usual with itemized deductions, taxpayers will have to determine if they are better off with the standard deduction or the itemized deduction. Now, however, taxpayers have a couple more choices. They will have to determine if they are better off with the sales tax deduction or the income tax deduction, and, for the sales tax deduction, whether they are better off using actual sales taxes paid for the year or the Internal Revenue Service tables plus actual taxes for certain big-ticket items such as motor vehicles and mobile homes.
All of this will also have to take into account the impact of the phase-out of itemized deductions and the alternative minimum tax, for which the sales tax deduction is a disallowed preference item.
Since the provision creating the new sales tax deduction for 2004 did not come into the law until October of 2004, many taxpayers may not be able to put their hands on all of the sales tax receipts for their expenditures for the year. This may force a lot of taxpayers who otherwise might be better off with actual payments to use the tables for 2004.
The IRS has now released the tables in Publication 600. In order to take maximum advantage of the tables, taxpayers are going to have to assemble some information that they may not have been accustomed to compiling in the past.
Publication 600
The IRS sales tax tables published in Publication 600 look very similar to the tables published by the IRS until 1987, when the old sales tax reduction was repealed by the Tax Reform Act of 1986.
In the left column, the taxpayer must select her total available income. This would include not only the taxpayer's adjusted gross income but also various items of nontaxable income, including tax-exempt interest, veterans' benefits, nontaxable combat pay, workers' compensation, the nontaxable part of Social Security and railroad retirement benefits, the nontaxable part of IRA, pension, or annuity distributions (not including rollovers), and public assistance payments.
Although it may require some effort for the taxpayer to collect this information, collecting as much income information as possible will help to create a larger deduction for sales taxes.
Once the appropriate level of income is selected, the taxpayer next must select from the top row the appropriate number of exemptions. This should be easy, since the number can be pulled from Line 6d of the Form 1040. Now, using the appropriate income number and the appropriate exemption amount, the taxpayer can pull the correct number from the table.
Unfortunately, however, the number from the table is just the first step in a three-step process. The second step requires the taxpayer to calculate any local general sales taxes, and the third step requires the taxpayer to add general sales taxes paid on specified items.
Local general sales taxes
It has become fairly common in many states for counties and municipalities to impose their own additional sales taxes. There had been some hope that Publication 600 would include expanded tables to cover at least those local rates that impact a significant number of taxpayers. The IRS, however, chose not to do so.
Instead, each taxpayer will have to determine both the local tax rates (city and county) that apply to the taxpayer's place of residence, and the state general sales tax rate, divide the former by the latter and multiply times the figure computed from the table to determine the allowable amount of local sales taxes.
The instructions back in 1986 included the state general sales tax rate on which the tables were based. Publication 600, however, does not include the state general sales tax rates on which these new tables were based.
This leaves residents in states like Hawaii trying to guess whether the IRS considers the Hawaii general excise tax a general sales tax only as applied at the retail level, or also at the wholesale and manufacturers level. (Based on the 1986 tables, it would appear that only the retail-level general excise tax in Hawaii is treated as a general sales tax.)
Taxpayers in metropolitan areas will often find that tax rates vary from one suburb to another. Taxpayers can ascertain the local tax rates that apply to them (irrespective of where they do their principal shopping) by checking with a retailer in the same community in which they reside or checking with their local municipal government. Tax practitioners may want to subscribe to one of the sales and use tax services that are designed to assist them in determining the rates applicable to their clients.
Although the state of Alaska has local sales taxes, but no state sales tax, Publication 600 states that Alaska taxpayers must only use actual expenses, since there is no state sales tax table provided for Alaska to use as a base for calculating allowable local taxes.
General sales taxes paid on specific items
We started out this discussion by saying that for 2004 many taxpayers will be stuck using the tables because they probably did not retain their actual receipts for the entire year. However, even with the tables, in order to take maximum advantage of the deduction, taxpayers must be able to determine the sales taxes paid on certain major purchases in order to add those actual sales tax payments to the figure pulled from the table.
These major purchases, as listed in Publication 600, include motor vehicles, aircraft, boats, homes (including mobile and prefabricated), or home-building materials. While the intention is to include major purchases, the amount of the purchase is not a criteria - a low-cost used car or minor building materials bought at a home-materials center qualify. So does sales tax paid on a leased vehicle - but the purchase of expensive jewelry does not.
In any event, hopefully taxpayers will be able to determine at least the sales taxes associated with these major purchases, if made earlier in 2004. If the tax rate applicable to motor vehicles in a particular state or locality is higher than the general sales tax rate on other goods, the taxpayer may only add the portion of the sales tax paid that is equivalent to the general sales tax associated with other goods.
Taxpayers that are likely to benefit from the sales tax deduction in certain years may find that they can time some of their major purchases to take maximum advantage of the deduction in those years. Currently, the sales tax deduction remains on the books only for 2004 and 2005.
Other issues
Use taxes paid may be treated as a general sales tax if the use tax is complementary to the general sales tax and a deduction would be allowed for the sales tax on similar items sold at retail.
Code Sec. 164(b)(5)(H)(ii) states that the tables are to take into account filing status, number of dependents, adjusted gross income, and rates of state and local general sales taxation. The only reference to filing status in Publication 600 is a caution that, if your filing status is married filing separately and both you and your spouse elect to deduct sales taxes, then, if one spouse elects to use the tables, the other spouse must also use the tables.
The tables go up to incomes of $200,000. The statute had only required that the tables go up to the applicable dollar amount for the phase-out of itemized deductions (for 2004, $142,700), so the tables are more generous for higher income taxpayers than they needed to be.
The tables do tend to reflect that lower-income people spend a higher proportion of their income on goods than higher-income taxpayers. It is difficult to gauge how generous the tables are from what they had been back in 1986 (adjusted for inflation). For several states, the amounts allowed in the tables actually went down compared to the 1986 tables, probably due to changes in the tax structure in some of those states.
As a rough estimate based on the new tables, however, someone with an income of $20,000 is expected to spend around $6,700 on items taxed at the general state rate. Someone with $60,000 of income is expected to spend $12,700; $100,000 earners spend $15,900 at the general sales tax rate; and someone with $200,000 in income spends $24,600. To take the extreme, a Florida resident with $200,000 of income is allowed $1,474 as his general sales tax deduction in 2005. Offhand, keeping actual receipts seems to make sense.
Publication 600 also permits the taxpayer to prorate the sales tax deduction when a taxpayer has lived in more than one state during the year. However, taxpayers cannot prorate their choice between sales tax and income tax; only one or the other is deductible for the entire year. However, if a taxpayer chooses to deduct state income tax in one year and receives a refund for overpayment in the next year, the refund is income whether or not state sales tax is deducted in the next year.
When the code provision was drafted, some taxpayers were hoping that proof of actual sales tax paid through receipts would include an extrapolation of sales tax paid based on annual credit card statements of purchases grouped by types. With more taxpayers using plastic for almost all purchases, this might be a logical method of proof. The assumption was that the general and local sales tax could be determined from the gross amount of each purchase. While the IRS has not specifically said no to this method, it apparently is looking only to receipts in which the sales tax is separately stated.
Summary
The tables and worksheet in Publication 600 will become another essential part of the tax return preparation process, and represent another instance in which the simplifications achieved in the Tax Reform Act of 1986 have gradually slipped away.
Although clearly essential in states with only a sales tax and no income tax, even in states with both an income and a sales tax it will often be advisable for the tax return preparer to at least assemble the information to check to see if a sales tax deduction might be more beneficial for the taxpayer.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a WoltersKluwer company.
