The Growing Trend of Pass-Through Entity SALT Cap Workarounds
By: Tony Konkol, Manager, State & Local Tax and Cathie Stanton, Partner, National Leader State & Local Tax
In December 2017, the S&P 500 was on the cusp of a historic close over 2,700 points and the word “pandemic” was hardly in our lexicon. Tax professionals everywhere were buzzing about the passage of the Federal tax reform law known as the Tax Cuts and Jobs Act (TCJA). One of the most controversial provisions of the TCJA was a limit of $10,000 on the amount of deductible state and local taxes for many individual taxpayers that has since come to be known colloquially as the “SALT cap.”
Understanding the Tax Provision & SALT Cap
Under prior law, taxpayers who itemized deductions on their federal income tax return could deduct amounts paid for state and local taxes in full. Beginning in 2018, the itemized deduction for state and local taxes paid is limited to $10,000 per return for single filers, head of household filers, and married taxpayers filing jointly; the cap is $5,000 (each) for married taxpayers filing separately. As a result, taxpayers with state and local tax expenses during the year that exceed their respective caps lose the additional deduction for federal tax purposes. The TCJA’s SALT cap was enacted as a temporary measure that will expire at the end of 2025, unless subsequent legislation is enacted to extend or make it permanent.
Almost four years since the TCJA was enacted, the controversy surrounding the SALT cap has yet to wane. The effects of the SALT cap are generally felt disproportionally by residents of higher-tax states such as New York and New Jersey, and as proponents argue that a full repeal of the SALT cap would mostly benefit high-income households. A staunch Democrat-led coalition in Congress, mainly representing high-tax states, remains tenacious in advocating for full, or partial repeal of the SALT cap. Most recently, by voicing opposition to a budget reconciliation package that doesn’t provide for lifting the SALT cap or fully restoring the state and local tax deduction altogether.
Entity-Level Tax Legislation
However, the TCJA’s SALT cap only applies to individuals –it does not apply business entities. In response, several states have enacted legislation since the passage of the TCJA to impose an entity-level income tax on pass-through entities (PTEs), such as S-Corporations and Limited Liability Companies, motivated by an intent to circumvent the TCJA’s $10,000 SALT cap and provide relief to individual taxpayers affected by the limitation. Since individual owners of PTEs report their proportionate share of business income on their individual income tax returns, these entity-level tax workarounds shift state taxes on PTE income from the individual owner, back to the PTE itself.
The trailblazer of the new wave of states to pass entity-level PTE tax legislation is Connecticut, which passed a mandatory entity-level tax on PTEs in May of 2018 (and remains the only state to mandate an entity-level income tax on PTEs). Since then, an additional 19 states have since joined the fray by enacting legislation that would allow an optional election to be taxed at the entity-level, which include: Alabama, Arizona, Arkansas, California, Colorado, Georgia, Idaho, Illinois, Louisiana, Maryland, Massachusetts, Minnesota, New Jersey, New York, Oklahoma, Oregon, Rhode Island, South Carolina, and Wisconsin. On the sidelines, Michigan, North Carolina, and Pennsylvania have introduced legislation, that if passed, would allow a PTE the election to be taxed at the entity-level.
While the mechanics of each states’ entity-level tax on PTEs vary, they generally follow one of two methodologies:
- Income that is taxed at the PTE level is excluded from the owner’s state taxable income.
- The PTE owner’s share of distributed income is passed through in the usual fashion, but the individual owners are allowed a “credit” for the tax paid by the PTE.
It should be noted that while a majority of states are adopting the “credit” methodology, the issue of whether PTE owners will be allowed a credit for taxes paid to other states on their resident individual income tax returns for income taxes paid by the PTE to other states has largely yet to be addressed in legislation or guidance, leaving uncertainty whether PTE owners having business income in early-adopter states may ultimately be able to realize the full benefit of these SALT cap workarounds.
In an IRS notice released in November 2020 (Notice 2020-75), it was announced that proposed regulations will be issued to explain the manner which state taxes imposed on PTEs at the entity-level can be deducted by the pass-through entity in computing its non-separately stated taxable income or loss for the tax year of the payment. On the surface, it may appear that the IRS is giving its blessing, or at least acquiescence, to these state efforts, but there remains concern among tax professionals that the IRS may still reverse course and issue regulations or other guidance less favorable to these state SALT cap workarounds. As these state workarounds currently stand, there remains uncertainty and issues on the federal income tax side to consider regarding potential special allocations, deemed distributions, and effects on Section 199A calculations.
In addition, benefits of the entity-level PTE Tax elections may not be recognized by all owners equally, and consideration may need to be given to amending partnership agreements if elections are made and ultimately benefit some partners at the expense of others, if federal or state law provide for no other way to rectify.
With 23 states already having passed or introduced legislation to impose income tax on PTEs at the entity-level and the IRS indicating a position that would tolerate these state workarounds, it is likely that we will see even more states following suit.
For highly profitable PTE taxpayers, substantial benefits may be recognized by these state entity-level tax elections under the right factual situations. However, while these state SALT cap workarounds may seem simple on the surface, there are many technical aspects to consider from both the federal and state income tax perspectives. By monitoring and tracking legislative developments in this area, Cherry Bekaert’s Strategic Tax Advisory professionals can provide a thorough, holistic analysis of potential outcomes for PTEs considering these elections and can help you understand the potential impacts and opportunities for your business.
If you have any questions or need more information about the pass-thru entity tax provisions, please reach out to your tax advisor or a Cherry Bekaert State & Local Tax Professional for assistance.