One of the most controversial elements of the federal Tax Cuts and Jobs Act (TCJA), passed three years ago, is the “SALT Cap” limiting an individual’s annual itemized deduction for state and local income and property taxes to $10,000. Prior to 2018, individuals could deduct an unlimited amount for state, city, and local income and property taxes for regular federal income tax purposes, although such deductions were not allowable under the Alternative Minimum Tax regime.
Governors of high-tax states such as California, Connecticut, New Jersey and New York have viewed the SALT Cap as a vindictive measure and have brought suit against the government in federal courts, but so far their claims have not met with any success.
President Biden has vowed to repeal the SALT Cap and it is also a favorite target of congressional Democrats, making its repeal possible during the Biden Administration.
State fixes for the problem
Since the TCJA’s passage, several states have sought ways to circumvent the SALT Cap. In 2018, the state of Connecticut enacted a “Pass Through Entity Tax” on Partnerships and S Corporations that do business in the state. Normally, partnerships and S Corporations are not themselves subject to income taxes, but under the CT PTE tax, the entity itself pays an income tax on its profits at a rate of 6.99%. The entity’s owners still report their share of the entity’s income on their Connecticut tax returns. However, they receive a credit against their personal Connecticut tax equal to 87.5% of their share of the tax paid at the entity level, so double taxation is at least partially avoided.
Because the tax is paid at the entity level, it is deductible in full for federal tax purposes as an “above the line” deduction. It is not subject to the $10,000 SALT Cap and is not a tax preference item for Alternative Minimum Tax purpose.
Even if Congress repeals the SALT Cap in 2021, these state work-arounds may still be valuable.
James M. Brower Jr.
Because the CT PTE tax was enacted in direct response to the SALT Cap, many tax professionals were concerned that the Treasury would draft regulations that would deny entity-level deductions for the tax. Previously, the Treasury successfully shut down other SALT Cap work-arounds that involved state or local tax credits in exchange for charitable “donations” to special charities. Therefore it seemed at least theoretically possible that similar regulations would be enacted with respect to state income taxes on passthrough entities.
Other states have enacted similar laws in recent years. In 2019, New Jersey enacted its “Passthrough Business Alternative Income Tax” (BAIT) under which passthrough entities (Partnerships and S Corporations) may elect to pay an entity-level tax on income derived from sources within the state. The entity’s owners receive a corresponding credit against their New Jersey income tax for their share of the tax paid by the entity. Maryland, Oklahoma and Rhode Island have enacted similar “elective” taxes on passthrough entities.
How the IRS has responded
On November 9, 2020, the IRS issued Notice 2020-75, which essentially blesses Connecticut’s SALT Cap work-around. The notice provides that entity-level income taxes imposed by states and municipalities on partnerships and S Corporations are deductible expenses at the entity level and do not have to be added back to taxable income at either the entity level or individual investor/owner level.
Now that the IRS has publicly provided assurance that state work-arounds like Connecticut’s are valid, we will probably see several other states start to enact similar laws. Currently legislation has been introduced in California, New York and Minnesota which, if enacted, would result in entity-level taxes on partnerships and S Corporations operating in those states, with individual and corporate owners receiving credits at the investor level for some or all of the taxes paid at the entity level.
Even if Congress repeals the SALT Cap in 2021, these state work-arounds may still be valuable. Taxes paid at the entity level will still be deductible above the line, would not be subject to re-instated limitations on itemized deductions, and would not constitute an Alternative Minimum Tax preference item.
If your clients are owners of a passthrough business entity, you may want to investigate whether or not electing-in to a state’s SALT Cap work-around is advisable.