There are advantages for business owners who qualify—but also risks and an uncertain future.
The $10,000 U.S. 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) may issue more guidance and that the future of the SALT deduction cap in Congress is unclear.
What is the $10,000 SALT deduction 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 deduction cap is applicable to individuals—but not entities. Aware of this distinction, almost all of the 41 states with a state income tax have enacted laws giving PTEs the option to pay state and local taxes at the entity level. This so-called “workaround” benefits individual taxpayers for U.S. 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.
The Treasury Department has not issued any material guidance on the SALT cap deduction since the 2020 notice.
Which states have enacted this PTE tax legislation?
So far, more than 35 states have passed laws offering an entity-level tax on PTEs, giving individual owners complete or partial SALT deduction cap relief. These laws have a variety of effective dates and other differences.
Can any business organized as a PTE use the SALT deduction cap workaround?
Generally, the workaround is available to operating businesses. Unfortunately, the extent to which a pure investment partnership can use it is less certain.
There is limited precedent on this point, and current IRS guidance does not clearly distinguish between PTE taxes paid on different types of income (i.e., 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 sources 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?
The SALT deduction cap is set to expire after 2025 absent Congressional action, but nonetheless we expect that the PTET election may continue to have value regardless of what Congress does or does not do.
What should you do now?
If you are an equity owner in a pass-through entity that operates in a state that has enacted this legislation, you should review these provisions to determine whether a PTE election is advantageous to all individual owners. 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.
1IRS Notice 2020-75, https://www.irs.gov/pub/irs-drop/n-20-75.pdf (November 9, 2020).
