State governments are worried about the potential loss of tax revenue after passage of the Tax Cuts and Jobs Act, and may be forced to restructure their tax laws.

New York Governor Andrew Cuomo announced plans Wednesday to sue the federal government over the new tax law, which limits state and local tax deductions to a maximum of $10,000 (see Cuomo plans to sue U.S. government over state tax break change). He estimates the change will raise property and income taxes for New Yorkers by 20 percent. Cuomo said the state is also mulling workarounds to the new tax law, including restructuring its income and payroll tax system and expanding the opportunity for taxpayers to make charitable contributions as a way to pay their income taxes.

Other states such as California are considering similar workarounds, such as having employers take out state income taxes as payroll taxes, or allowing taxpayers to make voluntary “gifts” of their taxes to the state that would be deductible as charitable donations.

A printout of Congress's tax reform bill, "The Tax Cuts and Jobs Act," alongside a stack of income tax regulations
A printout of the Tax Cuts and Jobs Act, alongside a stack of income tax regulations. Bloomberg News

However, at least one state tax expert is skeptical about the Internal Revenue Service allowing taxpayers to reclassify their state and local income taxes as charitable contributions. “That’s a big gamble and the IRS is very accustomed to people trying to reclassify their income as something else,” said Scott Peterson, vice president of U.S. tax policy at the tax software company Avalara. “They know how to deal with that, so I don’t think they’re going to allow any state to reclassify something as something that can be deductible. It’s an interesting concept. Instead of Los Angeles being a city, Los Angeles becomes a 501(c)3 charitable organization, and all the payments that you have to make to them become charitable deductions. Somebody’s being really creative. I don’t think the IRS is going to fall for that. It makes for great conversation, though.”

States are also putting renewed pressure on e-commerce companies to charge sales taxes on online purchases. The U.S. Supreme Court may decide this month to take up a case involving South Dakota, which is suing the online retailers Wayfair and Overstock.com. The case could overturn the precedent set in the 1992 Quill decision, which established the concept of nexus for determining whether states could charge income taxes on remote sales.

Last month the Government Accountability Office released a report estimating that state and local governments could gain between $8 billion and $13 billion in tax revenue per year if states were given the authority to require sales tax collection from all remote sellers, such as e-commerce websites (see States could gain billions from taxing online sales). Peterson, who was formerly executive director of the Streamlined Sales Tax Governing Board, and director of the Business Tax Division of the South Dakota Department of Revenue and Regulation, helped GAO researchers with the report.

“Every time Congress changed their corporate income tax, the state would have to hire an economist and a CPA to look at how that would affect the income reported by banks in South Dakota to see does this increase revenue to the state, or does it decrease revenue to the state,” said Peterson. “Regardless of whether there was a positive or a negative, the state legislature would have to decide, 'Do we want to collect less revenue or do we want to collect more revenue?' It’s always a decision the state makes. The changes that Congress is about to make, while not radical in real scope, they’re huge in degree. Just about everything that’s part of the darn federal corporate and personal income tax has changed somewhat. There’s going to be an immense amount of work required by state legislature and state economists to try to understand how those things flow down to their taxes and whether they want that outcome or not.”

Back in 2013, the Senate passed the Marketplace Fairness Act, in an effort to establish a federal policy for the collection of state and local taxes from online merchants using the Streamlined Sales and Use Tax Agreement. However, the bill never made headway in the House after being bottled up in the House Judiciary Committee.

“In those years, I was up there meeting with members of Congress all the time,” said Peterson. “There are an awful lot of members of Congress that understand the issue. They believe that it is unfair to their local merchants, but when you flip the conversation around and say, ‘Yeah, I know it’s unfair for your local merchants when somebody who sells into the state doesn’t collect sales tax, but when your local merchants are selling in somebody else’s state, do you want them to be subject to that state’s sales tax?’ There’s a pause.”

He hears that such legislation to resolve these issues is still under consideration.

“There are conversations going on, I’m told,” said Peterson. “There are members of Congress who continue to have these conversations. They’re continuing to try to work through the language that would make a majority of the people happy.”

States may be forced to rely more heavily on sales taxes if income tax collections go down as a result of the Tax Cuts and Jobs Act. “There’s a bunch of states out there now that have budget deficits,” said Peterson. “It’s a bipartisan thing. Almost every Republican governor and almost every Democrat governor sees this as at least a partial solution to whatever funding problem they have.”

He believes the GAO report could become part of the debate for lawmakers on tax policy as they deal with the impact of the Tax Cuts and Jobs Act. He pointed out that it came in response to a request from Sen. Ron Wyden, D-Ore., the ranking Democrat on the Senate Finance Committee.

“This is something members of Congress have the ability to do,” said Peterson. “But this is an issue that the GAO has talked about before. What makes this important is it does validate the states’ claims that there’s money that goes uncollected, which everybody knows. It does validate industry’s point that there’s a competitive advantage if you don’t collect sales tax. It validates industry’s point that having to collect sales tax isn’t free. There’s an effort involved in doing that, and it validates the point that states are going to do whatever it takes to get everybody collecting. 2017 was the busiest year I’ve ever seen for sales tax compliance legislation. All kinds of bills were passed or debated all over the country. I think 2018 is going to be just as wild.”

Peterson pointed out that 31 states faced some type of revenue deficit in fiscal 2017, and 22 states still collect less tax revenue than at their pre-recession-era peaks, after adjusting for inflation.

Those struggles led to an unusually active tax year in 2017, with 36,254 tax changes, including rate and product or service taxability; and 80 sales and use tax compliance bills. In addition, 26 states offered amnesty on back taxes, penalties and interest for online marketplace sellers; 15 states introduced or proposed consumers’ use tax requirements for out of state online sellers; and 12 states proposed economic nexus on out of state businesses that reach the threshold of maximum gross receipts.

Peterson noted that both Amazon and Etsy are starting to collect sales taxes in Washington State this year. “I don’t want to say the states have given up on Washington or the Supreme Court, but the states have decided that they need to do something on their own, so they’re all passing these laws,” said Peterson. “And they’re going to continue to do that in 2018. Amazon is starting to collect on January 1 for all of their third-party sellers. Now that Etsy is going to start collecting for all of their sellers, states are going to see that and they’re going to immediately do exactly what Washington did.”

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