There are advantages for business owners who qualify—but also risks and an uncertain future.
The $10,000 U.S. federal cap on deductions for state and local taxes (SALT) is, understandably, on the minds of many taxpayers in high-tax states.
You may have heard about the “SALT cap workaround,” and wondered what it involves and whether you are eligible.
The short answer is: For some owners of pass-through entities (PTEs)—including partnerships, S corporations and certain LLCs—this strategy may enable you to deduct, indirectly, state and local taxes paid by the PTE, beyond the SALT cap.
Below, we answer a number of the other important and frequently asked questions about the SALT cap workaround. As you consider its potential usefulness, keep in mind that the Internal Revenue Service (IRS) plans to issue more guidance and that the future of the SALT cap in Congress is unclear.
What is the $10,000 SALT cap?
The 2017 Tax Cuts and Jobs Act temporarily capped the deduction for aggregate state and local taxes, including income and property taxes (or sales taxes in lieu of income taxes), at $10,000. The SALT cap is set to expire after 2025. For now, it mainly affects high-income earners who live in high-tax states and itemize deductions.
What is the SALT cap workaround?
The SALT cap is applicable to individuals—but not entities. Armed with this distinction, more than half of the 41 states with a state income tax have enacted laws giving PTEs the option (or even the requirement) to pay state and local taxes at the entity level. This so-called “workaround” benefits individual taxpayers for federal tax purposes in two ways:
- Individual PTE owners, who would have been subject to the $10,000 SALT deduction cap if they had paid state and local taxes directly, see the benefit of taxes paid by the PTE reflected in a reduction of their shares of PTE income
- For some PTE owners, the workaround may offer a greater net benefit than an itemized tax deduction, which might be offset by the alternative minimum tax and net investment income tax
Other benefits may be available, depending on facts and circumstances, particularly at the state level.
How does the IRS view this strategy?
In late 2020, the IRS expressly authorized the SALT cap workaround and announced its intention to issue further regulations.1
PTEs in states that have enacted entity-level tax laws can use the workaround for “Specified Income Tax Payments” made on or after November 9, 2020 (the date of the IRS Notice), or in certain circumstances, for taxes previously paid pursuant to a law enacted by a state or local jurisdiction (including the District of Columbia) prior to this date.
Which states have enacted this PTE tax legislation?
So far, more than 20 states have passed laws offering an entity-level tax on PTEs, giving individual owners complete or partial SALT cap relief. These laws have a variety of effective dates and other differences.
This table shows a list of U.S. states that have passed laws offering an entity-level tax on PTEs, as of Feb 24, 2022. The states include: Alabama, Arizona, Arkansas, California, Colorado, Connecticut (mandatory), Georgia, Idaho, Illinois, Louisiana, Maryland, Massachusetts, Michigan, Minnesota, New Jersey, New York, North Carolina, Oklahoma, Oregon, Rhode Island, South Carolina and Wisconsin.
Can any business organized as a PTE use the SALT cap workaround?
Generally, the workaround is available to operating businesses. Unfortunately, whether a pure investment partnership can use it is less certain.
There is limited precedent, and current IRS guidance does not clearly distinguish between PTE taxes paid on different types of income (e.g., trade or business income versus investment income).
Without more clarity on this issue, investment partnerships or family offices organized as PTEs may be reluctant to take an approach that could attract scrutiny from the IRS.
How does a PTE election work?
Most states that permit the PTE tax deduction allow PTEs to make an annual election by a deadline, with some form of notice to, or consent from, the PTE owners. PTEs need to plan ahead to give themselves time to contact all the owners and obtain consent, or wait out a notice period.
A PTE also may want to consider the jurisdiction of its owners and its source of income to determine the overall impact of making the election. The election could help some owners and harm others. PTEs with many partners or members in different jurisdictions might consider using separate feeder vehicles, if the tax savings justify the effort.
What is the outlook for the SALT cap workaround?
There are several potentially significant developments on the horizon.
- The Treasury Department has committed to issuing further guidance on the SALT cap,2 but the timing is uncertain
- The Supreme Court has not yet decided whether to hear the appeal of several states challenging the SALT cap3
- In Congress, attempts to increase the SALT cap seem stalled; but the cap will expire after 2025 without action
What should you do now?
Given the current uncertainties, taxpayers who have the luxury of time may want to wait and see. If you need to act soon, reach out to us with your questions to draw on our knowledge, experience and resources in this evolving area. Of course, you should also always consult your tax and legal advisors for advice specific to your facts and circumstances.
2 Department of the Treasury 2021–2022 Priority Guidance Plan, https://www.irs.gov/pub/irs-utl/2021-2022-pgp-initial.pdf (September 9, 2021).
3 New York v. Yellen, No. 21-966, https://www.supremecourt.gov/search.aspx?filename=/docket/docketfiles/html/public/21-966.html (January 6, 2022).