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The Tax Cuts and Jobs Act of 2017 (“TCJA”) introduced a general $10,000 limit on the amount of state and local taxes (“SALT”) a taxpayer can deduct for federal income tax purposes. This limit is scheduled to remain through 2025 and has significant tax consequences, especially to individuals in states with applicable income taxes.
For example, suppose a married taxpayer conducting business as a sole proprietor in a jurisdiction with an 8% flat tax rate has taxable income of $1,000,000 for the 2020 tax year, resulting in roughly an $80,000 state income tax liability. Prior to the TCJA, this amount was generally deductible for federal income tax purposes (subject to certain limitations). However, under current law the taxpayer is limited to a $10,000 deduction, resulting in a $70,000 lost deduction.
State solutions to the SALT deduction cap
In reaction, some states have attempted to circumvent the TCJA $10,000 limitation. One example is through the creation of an entity level tax on partnerships and S corporations (hereinafter “pass-through entities”). Generally, these entities do not pay income taxes because the income passes through to the owners, who then are taxed in their individual capacity. And these owners are subject to the $10,000 SALT deduction limitation.
However, the SALT deduction limit is generally not applicable for taxes imposed at the entity level. To take advantage of the disparity, some states (1) allow pass-through entities to elect to be taxed at the entity level or (2) mandate an entity level tax. While it was originally unclear whether this workaround would be respected by the government, the IRS, in Notice 2020-75, clarified that a SALT deduction is available to such entities.
As of today, 17 states (Alabama, Arkansas, Arizona, California, Colorado, Connecticut, Georgia, Idaho, Louisiana, Maryland, Minnesota, New Jersey, New York, Oklahoma, Rhode Island, South Carolina, and Wisconsin) have passed legislation approving an entity level tax. Six others (Illinois, Massachusetts, Michigan, North Carolina, Oregon, and Pennsylvania) have legislation pending.
Planning Opportunities for SALT deduction cap
Going back to the example above, suppose the jurisdiction at issue is a state allowing a pass-through entity to elect to be taxed at the entity level. The taxpayer, as a sole proprietor, cannot make such an election. This presents a tax planning opportunity. The taxpayer could consider switching from a sole proprietorship to an eligible entity classified as a pass-through entity for tax purposes, remembering that a partnership needs at least two owners for tax purposes (the taxpayer could consider admitting a spouse as a partner). By doing so, the taxpayer can now elect to be taxed at the entity level. Thus, the $1,000,000 of taxable income and $80,000 deduction will be imposed at the entity level rather than on the taxpayer as an individual.
As there is no SALT deduction limit at the entity level, the taxpayer can effectively claim a full federal income tax deduction for their individual state income taxes. Some states accomplish this via an income tax credit for all (or most of) the entity level tax paid while others permit the income taxed at the entity level to be excluded from an individual’s state taxable income.
Taxpayers considering this planning opportunity should consult their tax advisers to discuss specifics and remember not all states with an income tax have adopted an entity level tax regime. Further, those states that have adopted such a regime may impose entity level taxes at a higher rate than would apply to individual owners, possibly reducing the benefit. Finally, taxpayers should consider other consequences of converting to a pass-through entity, such as the reasonable compensation rules for S corporation owners.