The Iowa House of Representatives will soon take up a bill that would legalize cheating on your Iowa income taxes. While that isn’t the intent, it will certainly be the effect, at least for anyone who has an accountant or who can figure out how to do it on their own.
Officially, the bill is HF3, which would create an alternative flat tax of 4.5 percent. The taxpayer could choose between the current system and the flat rate. If you choose the flat rate, you get a standard deduction but cannot deduct federal income taxes, itemize deductions, or take any credits. But if you currently pay a higher rate than 4.5 percent, and don’t have a lot of deductions or federal income taxes, you might come out ahead picking the alternative flat rate.
To see how this opens the door to massive tax avoidance, you need to understand one important feature of Iowa’s income tax: federal deductibility.
Let’s say you earn $75,000 in Iowa adjusted gross income (AGI) for 2013 and you had $5,000 in federal income taxes deducted from your paycheck during the year. You can deduct the $5,000 from your AGI, leaving you with that much less income to pay tax on. But if you also got a refund check from the federal government in 2013 (because you had too much withheld during 2012, and deducted too much federal tax on your 2012 Iowa return), you have to add that back to your taxable income. This ensures that, over the years, you always end up deducting exactly what you actually paid in federal taxes.
HF3 changes the rules — and here’s how any taxpayer could game the system under HF3. Let’s call it, “Follow the 20,000.”
• First stop, your W-4. During 2013 you file a W-4 to have five times as much federal income taxes withheld from your paycheck as you really need to. (Or, if you are self-employed, pay quarterly estimated taxes five times what is required.) So when you go to file your 2013 Iowa tax in April 2014, you can deduct $25,000 from your income instead of $5,000. This lowers your Iowa tax bill considerably. If you were in the top 8.98 percent bracket, the extra $20,000 deduction would save you $1,796 on your state income tax. So you choose to file under the current system instead of using the flat rate.
• Why that’s a bad idea now. Under the current system, your strategy would bite you in the back the next year, because now the $20,000 excess withheld in 2013 comes back as a refund check in 2014. The $20,000 refund check from the feds in 2014 would have to be added back to your 2014 income. You have to pay state tax on it.
• Flat tax changes the game. If you can take the alternative flat tax for 2014, you will see a huge break. While you would not be able to deduct federal taxes withheld during 2014 under that scheme, you don’t have to add back the $20,000 refund check either.
So for 2014, you pick the flat tax alternative, and pay 4.5 percent on “all” your income — but in the state’s eyes, it’s like that $20,000 never existed.
• An endless payoff. By doing this, you magically avoid ever paying Iowa income taxes on that $20,000. You didn’t pay tax on it the year it was withheld, because that year you filed the old way and took federal deductibility. And you didn’t pay tax on it the next year, either, because that year you chose the flat tax alternative and didn’t have to add in the $20,000 refund check.
You could argue that if the Legislature makes it legal, it can’t be called cheating. But it sure smells like it. That’s a “tax avoidance” strategy useful only to those in the higher tax brackets.
And that strategy can be avoided if HF3 gets no further in the Iowa House.
Posted by Peter Fisher, Research Director