SALT Cap’s Ultimate Fate to Create Potential Traps for Business

Congress’ battle over the state and local tax deduction has shifted yet again, with Senate Republicans now considering the House’s $40,000 limit—but setting the rate back to $10,000 after five years. This debate is a personal tax issue, though, so why should a business owner care?

The answer is that it depends on whether the business owns an interest in a passthrough entity such as an S corporation, partnership, or multimember limited liability company, and/or is transferring passthrough entity interests as part of an estate plan. Changing the SALT cap to $40,000 presumably would be academic to passthrough entity owners who are using SALT workarounds, as they deduct their SALT at the entity level.

Depending on income, some passthrough entity owners in Washington, D.C., and the five states where no SALT workaround exists might be able to enjoy a higher state income tax deduction under a $40,000 cap than under the current $10,000 cap. These taxpayers would likely see the SALT cap increase as a positive, and they could deduct more state income tax on passthrough entity income on their 1040 tax forms.

While the workarounds are positive for many taxpayers, they can create landmines in business valuations of passthrough entities, such as complicating earnings’ tax affecting.

Passthrough entities pay no federal income tax. Instead, the owner reports and pays income tax personally on their share of passthrough entity income. In business valuations under the Fair Market Value Standard of Value, however, a company’s earnings are benchmarked against an after-tax cost of equity.

The cost of equity represents the rate of return required by a hypothetical investor to invest in the subject business. For private companies, deriving the cost of equity typically begins with data derived from public companies. As C corporations, public companies pay income tax at the entity level and report earnings net of income taxes. Their cost of equity is based on what market participants would expect to earn on the investment after taxes.

Conversely, passthrough entities report earnings on a pretax basis. Consequently, a rational investor would subtract the estimated income tax payable on income from the passthrough entity, as if it were a C corporation, when applying an after-tax cost of equity to value the subject interest. This process of tax affecting is when the application of an appropriate blended income tax rate, including federal, state, and local income taxes, to owner-level passthrough entity income to estimate the cash flow available to a hypothetical owner.

These resultant after-tax earnings are properly matched with an after-tax cost of equity in determining the value of the subject interest. Why is this important?

To illustrate, assume we are valuing an interest in a passthrough entity via the capitalization of earnings method, an income approach. Under this method, stabilized ongoing cash flow is divided by the cost of equity to yield the indicated value.

Suppose the subject passthrough entity shows stabilized ongoing cash flow of $2 million on a pretax basis, but $1.5 million on an after-tax basis, and a 20% (after-tax) cost of equity applies. Capitalizing pretax cash flow yields a value of $10 million compared to capitalizing after-tax cash flow, which indicates a $7.5 million value—a $2.5 million overstatement of value without tax affecting.

Now suppose the owner reports income from this passthrough entity of $500,000, on which the owner owes SALT of 10%. If a workaround is used, the SALT deduction is $50,000.

Without a workaround, under current law, the SALT deduction is $10,000, but the proposed $40,000 cap creates a potential increase of $30,000 in the owner’s SALT deduction.

At the 21% federal corporate income tax rate, this would produce maximum federal income tax savings of $6,300—immaterial to total cash flow. Nonetheless, an appraisal of this subject interest should consider the increased SALT deduction in deriving the cash flow available to the passthrough entity owner.

If the differences are minuscule, why should a business owner care? Because failing to properly account for these changes, though small, could be troublesome in estate and gift tax business valuations due to the IRS’s continued resistance to tax affecting. While a settled issue among business valuation professionals, tax affecting of passthrough entity earnings remains a contentious issue in disputes with the IRS over business value.

To compound matters, over the last quarter century, the US Tax Court has tended to disallow tax affecting altogether when it’s poorly developed, rather than correcting the calculation.

As a result, the IRS is motivated to continue its fight against tax affecting, frequently disputing this issue. In my experience, this often results in material overvaluation of the subject business and consequently greater tax liability, penalties, interest, and legal and other professional fees needed to defend the taxpayer against the IRS.

When the $10,000 SALT cap passed in 2017, it upset taxpayers residing in states with high income tax rates—including California at 13.3%, Hawaii at 11%, and New York at 10.9%. Residents of such states had grown accustomed to deducting their state income taxes, so naturally, legislators received complaints related to the new cap.

In response, 36 states and New York City implemented SALT workarounds, allowing passthrough entities to pay and deduct state and local income taxes on behalf of their owners, circumventing the personal SALT limit. Maine and Pennsylvania have pending passthrough entities tax bills, whereas Washington, D.C., Delaware, North Dakota, and Vermont haven’t proposed creating passthrough entity tax workarounds. Many companies have operations in multiple states, some with SALT cap workarounds and some without—another potential trap.

As the debate over the SALT cap continues, tax and valuation advisers should stay informed about new, current, and expiring tax legislation and its potential impact on clients with interests in one or more passthrough entities. Advisers and their clients should plan accordingly to establish a safety net in response to these developments.

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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