Following enactment of the state and local tax deduction limitation in the Tax Cuts and Jobs Act in 2017, many states began looking for structures to circumvent the limit. These included trying to shift to a deductible charitable contribution, shifting to a payroll tax, and shifting to an entity-level tax.
The Internal Revenue Service took a dim view of the charitable contribution approach, and the payroll tax approach appeared to be too complicated to implement. However, the entity-level tax has been blessed by the IRS, leading to a stampede among states to implement that approach.
Notice 2020-75
Notice 2020-75, issued Nov. 9, 2020, states that the IRS intends to issue proposed regulations clarifying that state and local income taxes imposed on and paid by a partnership or an S corporation are allowed as a deduction by that entity in computing its taxable income or loss in the year of payment. The notice also clarifies that the rule applies in a tax year ending after Dec. 31, 2017, covering the period back to implementation of the state and local tax deduction limit.
Early adopters
Connecticut was the first state to enact a pass-through entity-level, or PTE, tax in response to the SALT deduction limit. In acting prior to the clarifications from the IRS, Connecticut created a mandatory entity-level tax to improve chances of passing IRS scrutiny. It turns out that the mandatory approach was not necessary, and other states have adopted elective provisions.
While pass-through entities are not taxed at the federal level and generally have not been taxed at the state level, a few states, such as Virginia, Maryland and Ohio, already had taxes on pass-through entities. Maryland had already acted to apply its PTE tax regime to the SALT deduction issue prior to Notice 2020-75. Other early adopters included New Jersey, Oklahoma, Rhode Island and Wisconsin. —
Expanding state adopters
Other states that have acted to provide a PTE SALT deduction workaround include Alabama, Arizona, Arkansas, California, Colorado, Georgia, Idaho, Louisiana, Minnesota and South Carolina. The Illinois legislature has also passed legislation, but as of this writing, it had not yet been signed by the governor. Massachusetts and Michigan also had provisions pass their legislatures that were vetoed by their respective governors.
Many other states also have proposals before their legislatures, and the list of states enacting these provisions is expected to continue to grow.
Varied statutes
As is often the case with states enacting statutes to address a similar issue, each state has enacted its own version of the legislation, creating compliance problems for taxpayers and their tax advisors operating in multiple jurisdictions. In some states, the pass-through entity owners get a credit, in other states an exclusion.
States have different rules as to the types of pass-through entity owners to which the provision applies and different rules with respect to nonresidents. States also apply different tax rates that appear in some cases to not permit a full and complete offset for the entity owners to the tax paid by the entity. And, of course, at this point, many states have still not taken action and those that have taken action have different effective dates for their provisions. Trying to take advantage of these provisions is likely to be another significant complexity for tax return preparation.
Planning
Existing pass-through entities will have to deal with some owners who may want to make the election and others who do not. The SALT deduction limit is already scheduled to expire under current law after 2025. Democrats in Congress have been pushing to eliminate or modify the deduction limit, but President Biden did not include a provision addressing the SALT deduction limit in his Fiscal Year 2022 budget. One of the problems that Democrats have in pushing to modify or eliminate the deduction limit is that the effort is criticized as an effort that primarily benefits the wealthy.
Some sole proprietors may look at setting up PTEs for the first time to take advantage of this workaround. It will require a cost-benefit analysis to compare the additional costs to the potential savings, taking into account the fact that the SALT deduction limit may not have a long future in its present form in any event.
Pass-through entities operating in multiple states will also have to sort through the differing provisions that apply and work through even possible double tax issues from provisions that are supposed to be providing a tax benefit.
