NYC Area’s Wealthiest to Feel Biggest Sting From SALT Court Loss

The US Court of Appeals for the Second Circuit has closed the book on attempts by New York, New Jersey, and Connecticut to bypass the federal cap on personal state and local tax deductions. On the surface, the decision looks like a sweeping loss for high-tax states.

But thanks to the expanded $40,000 cap and the ubiquity of pass-through entity workarounds, only a thin slice of wealthy households in the New York tri-state area—those with nonbusiness-related SALT liabilities exceeding the cap—are left without relief. For others, business as usual continues.

The states argued that their charitable credit programs—structures that encouraged residents to “donate” to state-affiliated funds and receive near-dollar-for-dollar state tax credits—were permissible under the Internal Revenue Code.

The court disagreed, siding with the Treasury Department’s 2019 regulations that prohibit taxpayers from recharacterizing tax payments as deductible gifts.

Safety Valves

Since the SALT limit was introduced in the 2017 Tax Cuts and Jobs Act, most households that previously felt the SALT pinch found relief through two safety valves:

• The expansion of PTE workaround tax elections, now in place in 36 states, which allow businesses organized as PTEs to pay and deduct their owners’ state income taxes at the entity level
• Congress’ expansion of the SALT cap from $10,000 to $40,000 through 2030, subject to a phaseout for filers with income over $500,000.

New York, New York City, New Jersey, and Connecticut all offer PTE workaround elections, allowing PTE owners to deduct state income taxes at the entity level, rendering this decision largely inconsequential for them.

From a valuation perspective, the marching orders haven’t changed. PTE earnings are reported on a pre-tax basis. Since the cost of equity (rate of return) used in valuation is derived from after-tax public company (C corporation) data, PTE earnings must be converted to after-tax earnings by using a process known as “tax affecting” before the cost of equity is applied.

Applying ‘Tax Affecting’

Tax affecting is the development of after-tax PTE earnings by subtracting estimated income taxes as if the PTE were a C corporation. Without a PTE workaround election, tax affecting is applied at a blended federal, state, and local income tax rate.

When a PTE election is in place, however, tax affecting is applied using only the federal income tax rate to avoid double-counting SALT deductions. For example, if a PTE operates only in New Jersey, Connecticut, and New York, and holds active workaround elections in all three states plus New York City, the tax affecting rate applied to earnings would include only federal income tax.

To understand the possible consequences, assume we are valuing an interest in PTE using an income approach called the capitalization of earnings method. Under this method, we divide the ongoing after-tax expected cash flow by the capitalization rate (the cost of equity minus the growth rate), yielding the indicated value.

Suppose the subject PTE shows stabilized pre-tax cash flow of $2 million, a 15% capitalization rate applies, the applicable federal income tax rate is 21%, and workaround elections are in place for all applicable states and cities. Tax affecting yields after-tax cash flow of $1.58 million divided by the 15% capitalization rate, yields an indicated value of $10,533,333.

Now assume the same facts, except the appraiser overlooks the workaround election deductions and applies a blended income tax rate of 30%. This scenario produces after-tax cash flow of $1,4 million, divided by 15%, which indicates a $9,333,333 value.

In that example, the incorrect application of tax affecting has resulted in a $1.2 million understatement of value, which is subject to assessment of additional tax, interest, and penalties.

These mechanics matter in the New York tri-state area, given its high state and local income tax rates and the availability of state and city income tax workarounds, two things which lend themselves to valuation traps in the form of improper, high-magnitude double benefits for state income taxes.

As shown above, errors in the effective tax rate can translate into large valuation errors when capitalized. In estate and gift settings, those errors can compound into significant tax, interest, and penalty exposure.

Implications for Households

Taken together, PTE SALT workarounds and the $40,000 personal SALT cap mean the loss of charitable-credit benefits primarily affects only households in these states whose property taxes plus state and local income taxes on nonbusiness income exceed $40,000 (subject to the phaseout).

Those who stand to benefit include high-income households with income from sources other than an operating PTE, such as wages, other business income, and portfolio and rental income, especially those who pay high property taxes on expensive homes.

Household SALT burdens in the New York tri-state area average about $13,000 to $15,000, falling far short of the $40,000 SALT cap. To reach or exceed the limit, taxpayers typically need nonbusiness income or property taxes nearly triple the area average, leaving out most area households.

Consider a New Jersey household with $50,000 in SALT: $20,000 from an S corporation and $30,000 from wages and property taxes. With a PTE election, the $20,000 entity-level tax is fully deductible, leaving just $30,000 of personal SALT—well within the expanded cap. If instead the household owed $50,000 in SALT from wages and property taxes, the SALT deduction would be limited.

Bottom Line

At first glance, tri-state taxpayers might place undue worry on the impact of this decision, but any effect is muted by SALT workarounds and the expansion of the SALT cap to $40,000.

Households hit in the tri-state area are those with average state and local tax expenses (that aren’t deductible through a SALT workaround) of nearly three times the area average, indicating high income and/or real estate ownership. Taxpayers who are or fear they might be affected should consult a tax adviser.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

Bruce C. Wood is director at Applied Economics LLC in Atlanta and a business appraiser specializing in IRS-related valuation matters.

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