State Payroll Tax Shift Stands on Solid Legal Ground

As readers of this blog know, I’ve suggested (here and here — and, along with 12 other tax law professors including co-bloggers David Gamage, David Kamin, and Darien Shanske — here and here as well) that states can soften the blow from the GOP tax bill by shifting some of their revenue-raising from personal income taxes to payroll taxes. For example, Illinois could replace its 4.95% income tax with a 5.208% employer-side payroll tax and an offsetting employee-side wage exclusion or credit. Under current law, if my employer pays me $100, I have to pay $4.95 to the state, leaving me with $95.05. Instead, the employer could pay me a wage of $95.05, and pay a state payroll tax of 5.208% x $95.05 = $4.95, for a total out-of-pocket cost of $100. A new wage exclusion or wage credit would offset my remaining Illinois income tax liability. We’re both just as well off as before, except that my gross income for federal tax purposes has fallen from $100 to $95.05. Assuming I’m in the 32% tax bracket and can’t claim the SALT deduction (either because I claim the standard deduction or — as in the case of many homeowners in the Chicago area — I hit the $10,000 SALT cap based on property taxes alone), I save roughly $1.58 in federal income taxes.

Co-blogger Brian analyzed this “salary upcycling” proposal in a post here yesterday; the Tax Foundation published a report addressing the proposal this morning. Brian concludes that “current law probably is mostly consistent with the upcycling proposal.” The verdict from the Tax Foundation’s Jared Walczak is more tentative: he says that the proposal “might be on somewhat firmer footing” than an alternative involving state charitable credits, but he flags “potential legal issues” worth considering.

I’m (unsurprisingly) much more optimistic that the payroll tax shift would hold up in court. But first, it’s worth understanding the objection raised by the Tax Foundation report:

Certainly there is nothing to prevent states from shifting to employer-side payroll taxes, and it is undeniably true that such tax payments are deductible. The credit, however, poses potential legal issues. The IRS might well conclude that this is little more than a shell game, with the employer effectively remitting the employee’s income tax payments on his or her behalf. . . .

In Old Colony Trust Co. v. Commissioner, the Supreme Court ruled that any amount that a third party spends paying someone’s tax liability is itself taxable income. If that amount is paid by the third party, it too is taxable, ad infinitum. The problem can be solved using a geometric progression formula, but under the proposal, after employer and employee were theoretically made whole, the employee would in fact face a new tax bill.

I’ll start with where we all agree: my employer can deduct the full $100 in wages plus payroll taxes. That much is clear from the text of section 164, which — even after the recent round of amendments — allows a deduction for “State and local . . . taxes . . . which are paid or accrued within the taxable year in carrying on a trade or business.” (Forget about the fact that my employer, the University of Chicago, is tax-exempt anyhow.)

We disagree, though, on whether the IRS could plausibly argue that my gross income is $100 rather than $95.05. First, if a flat-tax state such as Illinois simply excludes wage income from the tax base, then it’s hard to see what the basis for a gross-up would be. Surely there is no requirement that states tax wage income. Seven states have no income tax at all, and two more — New Hampshire and Tennessee — exclude wages from their income tax base.

Second, if a state introduces a wage credit to offset employees’ personal income taxes, the IRS would have no basis under existing law for arguing that the wage credit should be added to gross income. The Supreme Court has said that “the ‘receipt’ of tax deductions or credits is not itself a taxable event,” and it “would require compelling evidence” before concluding that Congress intended otherwise. See Randall v. Loftsgaarden, 478 U.S. 647, 657 (1986). More recent Tax Court cases reach the same result. See, e.g., Maines v. Commissioner, 144 T.C. 123, 135 (2015) (“credits are not an accession to wealth ‘as long as they are used to offset or reduce the [taxpayer]’s own State tax responsibility’” (quoting Tempel v. Commissioner, 136 T.C. 341, 351 n.17 (2011)).

Third, Old Colony Trust in inapposite. In that case, the taxpayer, William Wood, owed approximately $1 million in federal income taxes, which his employer, American Woolen Company agreed to pay on his behalf. The Supreme Court, in an opinion by Chief Justice William Howard Taft, said:

[W]e think the question presented is whether a taxpayer, having induced a third person to pay his income tax or having acquiesced in such payment as made in discharge of an obligation to him, may avoid the making of a return thereof and the payment of a corresponding tax. We think he may not do so. . . . The discharge by a third person of an obligation to him is equivalent to receipt by the person taxed. . . . We think therefore that the payment constituted income to the employee.

Old Colony Trust Co. v. Commissioner, 279 U.S. 716, 729 (1929).

If my employer pays me $95.05 in wages and then pays $4.95 in state payroll taxes, then in no sense have I “induced a third person to pay [my] income tax.” The $4.95 payroll tax is my employer’s legal obligation, not mine. This isn’t a privileging of form over substance. If American Woolen Company had failed to pay Wood’s income tax, American Woolen Company might have been liable for breach of its promise but Wood is the one who would owe $1 million to the federal government (and the one who — in the worst-case scenario — would end up behind bars.) If my employer fails to pay the state payroll tax, it’s the one on the hook legally — not me.

Finally, the observation in the Tax Foundation report about “the employee . . . fac[ing] a new tax bill” is simply an error in the report that should be corrected. If, hypothetically, the IRS considers the $4.95 payroll tax to be my employer’s payment of state taxes on my behalf, then my federal gross income is $100, and I can claim a $4.95 SALT deduction if I itemize and am under the $10,000 cap. In no circumstance am I worse off than before the payroll tax shift.

The stacking issue in Old Colony Trust is analytically distinct. Let’s say I earn an additional $100 and I’m in the 37% federal income tax bracket. Let’s also say that my employer and I enter into an arrangement like Wood and American Woolen Company, with my employer agreeing to pay the $37 on my behalf. Now, my federal gross income is $137. But then my tax is 37% x $137 = $50.69. But if my employer pays the $50.69, then my federal gross income is $150.69, and my tax is 37% x $150.69 = $55.73. Which my employer has to pay. And so on.

Old Colony Trust is a fun case to teach. Students quickly realize that the result is not that American Woolen Company pays an infinite amount in taxes. (Instead, it pays, in the example above, $100/(1–0.37)–$100 = $58.73.) But the fun stacking issue only arises because of the curious arrangement between Wood and American Woolen Company, which is not replicated here. Under no circumstances would my federal gross income be above $100.

All of which is to say: The payroll tax shift relies on a straightforward application of settled principles of federal income tax law. I guess the IRS still could attack it. But if it does, it should lose.