On Nov. 9, 2020, the Internal Revenue Service issued Notice 2020-75. For the first time, the notice approves of one of the techniques that states have used to help taxpayers avoid the $10,000 cap on the deduction of state and local taxes. However, that technique, involving shifting the tax to a pass-through entity, such as a partnership or S corporation, is only available to owners of businesses, not employees. The result may be that a cap that was designed to put a limit on the SALT deduction of wealthier taxpayers may now be able to be avoided by some of those same taxpayers. It is likely that this notice and expected regulations to follow could add to the movement to repeal or modify the cap.
The SALT deduction cap
The $10,000 state and local tax deduction cap was enacted as part of the Tax Cuts and Jobs Act in 2017. In legislation passed only with Republican support, it was designed to limit the tax benefit to states that imposed high taxes, primarily Democratic states. Ever since its enactment, many Democrats in Congress have been calling for its repeal or modification. Up until this point, those efforts have been unsuccessful.
High-tax states have also been at work trying to develop strategies to help their taxpayers preserve their federal tax deduction. Several states created state-sponsored charities with taxpayers permitted to receive a state income tax credit related to the amount contributed to the state-sponsored charity. This was designed to convert what would have been a deduction for state taxes into a charitable contribution deduction. In order to counter this approach, the IRS issued regulations in 2019 requiring taxpayers to reduce the amount of any charitable contribution deduction by the amount of any related state and local tax credit received. The regulations did provide a de minimis provision: no reduction in the charitable contribution deduction if the SALT credits received do not exceed 15 percent of the charitable contribution. It also provided a safe harbor: any disallowed charitable contribution deduction could be treated as a payment of state and local taxes up to the $10,000 limit.
As another means to try to provide a workaround, New York adopted a new payroll tax payable at the entity level, with employees receiving a corresponding credit to offset their individual income tax liability. This approach would appear to have some similarity to the approach permitted in Notice 2020-75, in that it shifts the tax burden to the entity level. Many businesses appear to have viewed this approach as cumbersome to adopt, which may be why the IRS has so far not taken a position on the issue.
Some states have also challenged the constitutionality of the SALT cap in court, arguing that it is a violation of the 10th Amendment to the Constitution. This litigation is still working its way through the courts.
The pass-through entity workaround
Connecticut in 2018 was the first state to enact an entity-level tax on pass-through entities. As of this writing, six additional states have adopted similar provisions: Louisiana, Maryland, New Jersey, Oklahoma, Rhode Island and Wisconsin. A few additional states have been considering the legislation.
Notice 2020-75 states that the IRS intends to issue regulations stating that PTE businesses are permitted to claim an entity-level deduction for “Specified Income Tax Payments.” This is permitted even where the entity-level tax shifts a tax burden from individual owners of the business entity. An SITP is any amount that a partnership or S corporation pays to a state, a political subdivision of a state, or the District of Columbia to satisfy an income tax obligation of the partnership or S corporation. It does not apply to U.S. territories. It applies whether the payment is mandatory or subject to an election and whether or not the partners or shareholders received a full or partial credit or other tax benefit based on their share of what the PTE paid to satisfy its tax liability. The SITP is not to be taken into account separately, but instead reflected in the partner’s or S corporation shareholder’s K-1 as their pro rata share of non-separately stated income or loss. The notice states that the regulations will also specifically provide that the SITP is not to be taken into account in determining the SALT limit.
As a result of this notice, many more states are likely to adopt similar legislation. It appears likely that they will adopt elective provisions, since that provides more flexibility, for example, where tax-exempt entities are involved as owners. However, as pointed out in the notice, the SITP option is only available to owners of these pass-through businesses, not to employees. Employees would not be permitted to set up a pass-through entity to be employed by the business.
The future of the SALT cap
Democratic efforts to repeal or modify the SALT cap may be enhanced by this notice. Some had been critical of Democratic efforts to repeal a provision that primarily affected wealthier taxpayers. Now, however, if the wealthiest of those taxpayers have a PTE workaround, it may help arguments that the provision is unfair to employees, as compared to business owners. A new Democratic administration in Washington may also be more supportive of repeal or modification efforts.
Effective date
Notice 2020-75 may be relied upon until regulations are issued. The seven states that had already adopted the PTE provision prior to Nov. 9, 2020, are permitted to apply the notice back to the later of the adoption of that state’s PTE tax provision or to payments made in a partnership or S corporation tax year ending after Dec. 31, 2017. Other states enacting PTE provisions may apply them to payments made on or after Nov. 9, 2020.
