BY LOWELL L. KALAPA – A highly compensated Bishop Street executive recently complained that his effective state tax rate was something on the order of 16% even though the nominal maximum state income tax rate is 11% for those folks making big incomes.

How is it so, you say, that someone could be paying an income tax rate greater than the nominal maximum rate?  Well, for these high-income individuals, making charitable contributions is one way to not only benefit the community, but it also provides a way to reduce the amount of their income that is exposed to the income tax.  In fact, earlier this legislative session the Senate Ways & Means Committee held a hearing on this very subject of limiting the amount of itemized deductions that could be taken by high-income individuals and folks who showed up were not the high-income taxpayers, but the people who benefit from those charitable contributions.

If readers will recall, last year lawmakers decided that another way they could raise more taxes to fill the budget shortfall was to limit the amount of itemized deductions that high-income earners could deduct as well as denying those same taxpayers from taking state income and sales taxes paid as an itemized deduction.  Once a single taxpayer realized $100,000 of federal adjusted gross income ($200,000 for couples), the limitation would kick in.

In the case of overall itemized deductions, once taxpayers reached those thresholds of federal adjusted gross income, no more than $25,000 could be deducted by single taxpayers nor more than $50,000 of itemized deductions for joint filers.  Perhaps lawmakers felt that taxpayers making that kind of income could afford to pay more in state income taxes by limiting those itemized deductions.  And, no doubt, those assumptions are probably true.

The problem, as many discovered, is that those wealthy are the very people who can afford to write a $10,000 check for a lead gift to a charitable organization.  In fact, members of the Ways & Means Committee, upon hearing the bill that would have repealed that limitation on itemized deductions, discovered that literally hundreds of charitable organizations reported that the limitation affected their ability to solicit major gifts for their organizations.  Thus, while lawmakers may have been eager to rake in more taxes, the unintended effect of the limitation on itemized deductions is that many charitable organizations will find it difficult to solicit large contributions at least until the limitation sunsets on January 1, 2016.

The other limitation that lawmakers adopted last year is a limit on the deduction for state income and sales taxes by both corporate and individual taxpayers.  Sponsored by the administration last year based on the argument that taxpayers can’t deduct the federal tax paid and withheld during the tax year from their federal adjusted gross income so why should taxpayers – in this case high-income taxpayers – be allowed to deduct the state income and sales taxes paid during the tax year from their state taxable income?

The problem with that logic is that for more than fifty years the state has attempted to maintain similarity, or conformity, between the federal definition of taxable income and the state definition of that income.  Maintaining conformity was cited as a top priority when lawmakers adopted the current conformity statute in 1978 as it made it easier for taxpayers to comply with and allowed administrators to utilize audits conducted by the Internal Revenue Service rather than state officials undertaking their own audit of net income tax returns.

By deviating from the federal definition of income, the differences mean one more calculation for taxpayers in figuring out their state income tax return.  Since the state income or sales tax deduction is available for federal purposes and not for the state, it will mean that the bottom line for itemized deductions will differ sending state officials scrambling to figure out what created the difference between the federal and state return.

The limitation on the deduction of state income and sales taxes will be permanent, unlike the limitation on all itemized deductions.  While arguably it is true that one cannot deduct federal income tax from adjusted gross income for federal or state purposes, eliminating the deduction of state income and sales taxes actually creates an additional cost for both the taxpayer and the administrator.