State and Local Tax Cap Workaround Gets Green Light From IRS

In a taxpayer-friendly development, the Internal Revenue Service (IRS) recently signaled it intends to endorse a workaround to the $10,000 cap on state and local income tax deductions. The proposed regulations will allow partnerships and S corporations to skirt the $10,000 cap on state and local tax deductions enacted under the Tax Cuts and Jobs Act. It will not help individual taxpayers who lack such structures, however.

State and Local Tax (SALT) Deduction Limit

Before the Tax Cuts and Jobs Act, the Schedule A deduction for state and local taxes (SALT) was unlimited. These taxes include:

• Real property taxes
• Personal property taxes
•  Income taxes
• General sales taxes
• War profits and excess profits taxes (these generally apply to industries that profit during periods of war and other crises)

Today, the Tax Cuts and Jobs Act limits an individual’s deduction to $10,000 ($5,000 if married filing separately) for the aggregate state and local taxes paid during the calendar year. For people who live in states with high income and property taxes, that $10,000 limit can be especially problematic.

Looking for Loopholes

Ever since the Tax Cuts and Jobs Act was enacted, high-tax states have looked for ways to help taxpayers get around the $10,000 cap. In 2019, for example, New York, New Jersey, and Connecticut proposed legislation that would have allowed residents to give money to a state charitable fund in place of taxes—and then deduct the payments as charitable contributions on their federal tax returns. The IRS and Treasury ultimately blocked the strategy.

More recently, however, states have been working on another option, which uses pass-through entities to dodge the cap—a workaround the IRS plans to approve. 

What Is a Pass-Through Entity?

A pass-through (aka “flow-through”) entity is a legal business entity that passes income on to its owners and investors. Any income generated by a pass-through entity is taxed only at the owner’s individual tax rate for ordinary income; the entity itself is not taxed. Pass-through entities are commonly used to limit taxation and avoid double taxation.

IRS to Allow Some Businesses to Dodge Cap on SALT Deductions 

The IRS recently green-lighted a workaround for pass-through entities, including S-corporations, some LLCs, and partnerships. A notice issued by the IRS says the proposed regulations will “clarify that Specified Income Tax Payments are deductible by partnerships and S corporations in computing their non-separately stated income or loss.”

That means that S corporations and partnerships can deduct specified income tax payments paid to state and local governments above the line—and not as pass-through items for partners and shareholders, where they would be subject to the $10,000 limit.

Most states tax pass-through entities at the owner level. So far, 13 states have enacted, proposed, or are considering laws that would tax the entities themselves.

“The Department of the Treasury and IRS are taking the necessary steps to provide fairness for America’s small businesses,” said Treasury Secretary Steven T. Mnuchin in a Nov. 9 statement. “These proposed regulations will offer clarity for individual owners of pass-through entities.” After the IRS finalizes its regulations, it’s likely that more states will consider similar workarounds.

The Bottom Line

The proposed regulations described by the IRS apply to specified income tax payments made on or after Nov. 9, 2020. However, the regulations make room for some taxpayers to amend their returns if they made specified income tax payments in a taxable year of a partnership or an S corporation after Dec. 31, 2017, and before Nov. 9, 2020—and the payment was “made to satisfy the liability for income tax imposed on the partnership or S corporation pursuant to a law enacted prior to Nov. 9, 2020,” according to the IRS notice.

If you’re a small business owner, ask your tax professional if you qualify for the workaround—and whether you should amend any previous tax returns.