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As Congress Passes on SALT, States Turn to Pass-Through Entities

Sept. 7, 2022, 8:45 AM

The Inflation Reduction Act includes a number of provisions addressing climate change, health care, and tax-related issues. Most notably on the tax side, it imposes a 15% minimum tax on corporations with profits over $1 billion, creates a new 1% excise tax on stock repurchases, and extends the limitation on pass-through business losses through 2028. But the law does not repeal or raise the $10,000 state and local tax deduction cap enacted by the 2017 Tax Cuts and Jobs Act, or TCJA. Since its adoption, high-tax states have been pushing for its repeal or, at a minimum, a higher limit for the cap itself.

Prior to the TCJA, all state taxes were fully deductible for federal purposes. Residents of high-tax states such as California, New York, and New Jersey received a greater federal benefit because they could deduct more state taxes (as a percentage) against their federal income. Unsurprisingly, the SALT deduction cap impacted residents of those high-tax states the most. In response to the cap, states began implementing workarounds in the form of pass-through entity taxes. These PTETs circumvent the SALT deduction cap for members of pass-through entities without impacting state coffers.

Since these workarounds involve pass-throughs, such as partnerships, LLCs, or S corporations, they don’t directly benefit W-2 taxpayers and tend to affect certain industries more than others. For example, service-based industries—such as real estate, law, medical, accounting, etc.—are more frequently organized as partnerships, while manufacturing, technology, and retail business tend to be organized as corporations.

Though the validity of these workarounds originally was questioned by some commentators, the IRS blessed them by releasing Notice 2020-75, which says that pass-through entities can claim entity-level deductions for state income taxes when PTETs are used to shift the tax burden from individuals to entities. Several states enacted PTETs prior to this notice, but since its publication, most states have adopted these laws.

While PTETs vary from state to state, they generally operate in the following manner: A taxpayer, who is a partner in a partnership (or a member of an LLC or shareholder in an S corporation) elects into the PTET. After doing so, the partnership pays the PTET based on its income, with most states adopting a provision that permits the partnership to include resident partners’ distributive share of income in the tax base.

The PTET rate is usually the same or similar to the state’s personal income tax rate. When the partnership subsequently distributes its income to its partners, the partners’ distributive share is reduced by the amount of the PTET that the partnership paid because the partnership deducted such amount for purposes of determining its federal taxable income. The partners’ reduced distributive share also reduces the partners’ federal taxable income for personal income tax purposes. The state in question then provides a personal income tax credit to the partner for the PTET paid, which results in an effective tax deduction for federal income tax purposes.

Despite the PTET being able to assist pass-through entities, it’s certainly not a cure for all taxpayers. Moreover, the failure to include a SALT cap repeal, or at least an increase in the SALT deduction cap, likely means it is here to stay until at least 2026, when the law sunsets. Unsurprisingly, most efforts to repeal the SALT deduction cap have come from legislators in high-tax states, such as New York and California, whose constituents have been hard hit.

However, repealing the cap has seen strong headwinds. Negotiations on the SALT cap deduction in the Build Back Better bill stalled when some viewed it as a tax break for wealthy taxpayers and not politically viable. It makes sense then that PTETs have gained prominence in such high-tax jurisdictions, as they can assist a certain segment of taxpayers.

What’s surprising, however, is that PTETs seem to have fairly broad support across all states, regardless of political leaning or how their representatives voted to limit the SALT deduction. States such as Alabama, Arkansas, Idaho, and South Carolina—whose senators all voted for the TCJA—have passed their own PTETs. This illustrates that a broad coalition of states have recognized the issues (meaning unhappy constituents) that have arisen due to the fairly dramatic move from an unlimited SALT deduction to one capped at $10,000.

It remains to be seen if the IRS upholds its taxpayer-friendly position voiced in IRS Notice 2020-75, as the agency may have a change of heart. But given the pronouncement in the notice, any such action would need to be done on a prospective basis, as the IRS generally honors its published guidance. It has publicly stated that it wouldn’t take a position adverse to a taxpayer that has relied in whole or in part on a public notice until more formal rulemaking procedures are enacted.

Even if the IRS attempts to revoke Notice 2020-75 and challenge the PTET regimes, they would almost certainly face legal challenges. States are sovereign and can impose their tax structures as they please—they aren’t even bound by federal treaties, though most do conform to them. We also would expect the IRS to push back on such a challenge or attempt to find ways to circumvent the effects of PTETs.

While states already have taken matters into their own hands by enacting PTETs, it will be up to Congress to decide what to do with the SALT deduction cap and whether to make it permanent when the law sunsets in 2026. Given the current political climate, it seems unlikely for any SALT deduction cap repeal will make its way through Congress until they’re forced to act.

Until then, taxpayers will need to grapple with determining the organizational structure that will benefit their business most. As the TCJA also reduced federal corporate tax rate to 21%, the new law just extended the limit on pass-through business loss. With most states having already adopted PTETs, many taxpayers may need to think twice about the pros and cons of how their structure affects their overall tax liability.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Mike Shaikh is a partner in Baker McKenzie’s Los Angeles office. He handles matters at administrative audit and appeal levels, as well as judicial proceedings on a variety of tax matters. He also provides tax advice on return positions, reorganizations, mergers and acquisitions, and other transactions.

David Pope is a partner in Baker McKenzie’s New York office. His practice focuses on state and local corporate income tax, sales and use tax, property tax, payroll tax, personal income tax, and unclaimed property in all states.

David Simon-Fajardo is an associate in Baker McKenzie’s Chicago office. He advises on tax planning in the fields of international and real estate taxation including both US and international clients.

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