The current state of SALT deduction cap workarounds
Variations in state passthrough entity (PTEs) taxes, as well as the potential relaxation or repeal of the state and local tax (SALT) deduction limitation (currently being deliberated in Congress via the Build Back Better (BBB) bill) have complicated the decision for passthroughs to elect to pay a PTE tax.
Background. Before 2018, individual taxpayers could claim a deduction for certain state and local taxes (SALT taxes) paid in a tax year. The deduction only applies to those who itemize deductions on returns.
The Tax Cuts and Jobs Act (TCJA) of 2017 limited the amount of SALT taxes an individual could deduct to $10,000 beginning tax year 2018 with a sunset of 2025.
The standard deduction also increased from $6,500 to $12,000. For 2022, the standard deduction will be to $25,900 for joint filers ($12,950 for single filers).
Workarounds for passthroughs. In May 2018, Connecticut was the first state to enact an option for PTEs to be taxed at the entity level. This option allows a PTE to be taxed similarly to a C corporation, instead of passing income to individual owners or partners.
To date, about half of the states have either enacted or proposed an optional PTE, with some becoming effective next year.
In November 2020, the IRS issued Notice 2020-75, 2020-49 IRB 1453, stating its intention to issue proposed regulations clarifying that "specified income tax payments" are deductible by a PTE in computing its non-separately stated income or loss.
A specified income tax payment is defined as "any amount paid by a partnership or an S corporation to a State, a political subdivision of a State, or the District of Columbia (Domestic Jurisdiction) to satisfy its liability for income taxes imposed by the Domestic Jurisdiction on the partnership or the S corporation."
The proposed regulations would apply to specified income tax payments made after November 9, 2020.
While the IRS has not recognized individual workarounds to the SALT cap deduction, Notice 2020-75 gave states a green light to enact their own PTE taxes. For more information about Notice 2020-75, see IRS will issue proposed SALT deduction regs for passthrough entities (11/11/2020).
BBB proposals. The version of the BBB bill as passed by the House increases the SALT cap from $10,000 to $80,000.
Opponents argue that raising the cap would only benefit the wealthy, while others believe that the cap should be repealed entirely.
Senator Bernie Sanders (I-VT) proposed to eliminate the cap only for individuals making under $400,000. Senator Bob Menendez (D-NJ) instead wants the threshold to be $550,000.
There is also uncertainty as to whether the cap will be extended beyond 2025.
Complications. A recent "Taxing Issues" webinar, held on December 8, discussed the challenges PTEs are facing with the SALT deduction cap and different state workarounds for the cap.
The webinar was hosted by Tax Analysts President and CEO Cara Griffith, who spoke with panelists Steve Wlodychak, retired principal and current contractor for EY LLP; Brian Reardon, president of the S Corporation Association and founder of Reardon Consulting LLC; and Alysse McLoughlin, a partner at Jones Walker's Tax Practice Group.
A core issue is how widely varied the different state PTE workarounds are and how states treat the different elections offered by other states.
Workarounds can come in the form of an income exclusion in some states, but as a credit in others.
In Louisiana and Wisconsin, for example, the workaround involves PTEs making an election to be treated as C corporations for state tax purposes. Conversely, in California, PTEs pay a 9.3% levy that owners claim as a credit on their California return.
This lack of uniformity "is what causes the complexity for taxpayers now when trying to figure out whether to elect into this," McLoughlin said. Businesses must also consider "where are their partners and where are their shareholders - what state are they a resident of?"
Some states may not offer a credit for taxes paid in another state, depending on where income is sourced and where the taxpayer resides. Even then, some state credits are not refundable or have limited carryover provisions.
New York released a list of states it would honor the respective PTE tax of, including Ohio's PTE withholding tax on the distributive share of income allocated to nonresident investors that predates the TCJA.
"The first question I have is: how come Virginia is not on the list, then?" Wlodychak posited. "Because Virginia has the very same taxes Ohio has... and yet [New York] chose Ohio and not Virginia."
For PTEs with members in different states, whether the entity elects to pay the optional tax is not always a straightforward or even unanimous decision, as some taxpayers may be disadvantaged by their state laws while other taxpayers wouldn't be.
"That's the biggest challenge," Reardon said. "Making sure that your shareholders are in states that are going to recognize the exclusion and credit."
Wait and see. To date, the IRS has not issued the proposed regs outlined in Notice 2020-75. In the absence of reliable guidance, interstate complexity will continue to increase as more states enact a PTE tax.
With the SALT deduction cap up for debate in Congress, it is uncertain whether such an elective tax will continue to be the most tax-advantageous option for businesses that have already made the election, or if the standard deduction will become more attractive.