By Jacob Boyd, CPA, Tax Manager; Amy Sandlin, CPA, Tax Senior Manager; Eric M. Bennett, CPA, Director
The Tax Cuts and Jobs Act (TCJA) capped the State and Local Tax (SALT) deduction to $10,000 for individuals who itemized their deductions for tax years beginning after December 31, 2017, and before January 1, 2026.
This cap was part of a trade-off that increased the standard deduction available to all taxpayers.1 It provided an overall increase in deductions for many, while also simplifying the tax returns for individuals who no longer benefited from itemizing but instead took the standard deduction.
This SALT cap applies to state and local real property taxes, personal property taxes, income taxes and general sales taxes. The $10,000 cap is the same for single and married taxpayers.
For taxpayers whose SALT deduction previously exceeded the $10,000 limit, their potential itemized deductions are lower compared to before TCJA.
For some taxpayers whose SALT deduction is limited under TCJA but still had total itemized deductions that exceeded the enhanced standard deduction, this SALT cap led to an overall increase in tax due to the inability to deduct all their state and local taxes.
Think about the typical taxpayer who might have SALT exceeding $10,000 while also having an amount of other itemized deductions sufficient to exceed the standard deduction. These are often high-income taxpayers – not the group politicians are most sympathetic to when they debate tax changes.
However, the cost of living varies drastically across the country, so what is considered “high income” in one area does not always translate to high income in another. One of the main arguments against the SALT cap is that it disproportionately affects taxpayers living in areas with high income tax rates coupled with high costs of living, such as New York and California.
As always, we are not here to contribute to that debate; we are here to provide guidance within the confines of the tax landscape today.
In response to the federal tax SALT cap, several states have passed SALT cap workarounds with the most common being the Pass-Through Entity (PTE) level tax (PTET).
Passthrough entities (partnership and S-corporations) generally pass their income on to individual owners, with the individual owners paying the tax on that activity by including it on their personal income tax returns. Since the individual owners pay the tax on the pass-through income, it is then subject to the $10K SALT cap.
However, the PTE itself is not subject to the SALT cap. PTEs are already subject to certain state and local income taxes and deduct them without limitation.
The general idea of the PTET is that the passthrough entity pays the state tax on its income, which it is also allowed to deduct in full. Effectively, this workaround allows an unlimited federal deduction for the income tax related to the PTE activity.
For a simple example of how PTET could benefit an individual owner, consider a PTE with $1M income subject to tax in a state with a 5% tax rate. The state tax rate in this example is the same for individual taxpayers as well as PTET taxpayers, and it assumes the individual owner itemizes and does not take the standard deduction.
Will you benefit from Pass-through Entity Level Tax?
There are currently 29 states that have enacted a PTE tax since the TCJA SALT limitation went into effect, and 2 more with proposed PTE tax bills. There are 10 states with owner-level personal tax on PTE income that have not yet proposed or enacted PTE taxes, and the remaining 9 states do not tax PTE owners on passthrough income.
We cannot overstate how complicated this analysis can become for a PTE. As of this writing, there is limited guidance on filing by state, and there are more questions than answers about how this will impact PTEs and their owners.
To give you a sense of the many factors in play, the states vary on:
- Elective or mandatory PTE level tax: some states now require PTE level tax, while it is elective for others. Who can make the election, when to make the election, and how often the election has to be made varies by state. Some states require the election be made as early as the return due date without extension.
- Owner restrictions: only certain types of owners may be eligible to benefit from PTE-level tax. For example, only individual owners may be eligible, while estates, trusts, corporations, and other pass-through entity owners may not be eligible.
- PTE owners may still have to file an income tax return for the state even though PTE-level tax was paid. The compliance cost alone for multi-state filers when compared to a PTE filing a traditional composite return on behalf of its owners may outweigh the benefit of PTE-level tax.
- Interplay with state rules for claiming a tax credit for taxes paid to another state: in general terms, most states have historically allowed resident taxpayers to claim a credit on their personal tax return to prevent double taxation on PTE income that has been taxed by another state. We could devote an entire article to individual states’ guidance (or lack thereof) on claiming this credit for PTE-level tax.
- Estimated tax payments: the PTE could be required to pay estimated tax payments during the year if it anticipates electing the PTE level tax, or it may be subject to underpayment penalties if it ultimately elects PTE-level tax and did not pay estimates.
- State tax rates for PTE level tax may differ from the individual income tax rates, which means you could have a scenario where the benefit of the unlimited SALT deduction does not outweigh the higher tax rate applicable for PTE level tax.
If TCJA was intended to limit SALT deductions, will the IRS allow this workaround?
IRS released Notice 2020-75 to announce its forthcoming regulations regarding PTET and certain other state and local taxes deducted by PTEs. It is expected the IRS will allow the PTE level tax as a workaround to the SALT cap.
This is welcomed news considering previous attempts at a SALT cap workaround have not gotten favorable treatment by the IRS. You may recall a few years ago, some states got creative and attempted to convert state income taxes into charitable contributions that would not be subject to the $10K cap. The IRS curtailed this workaround with final regulations in 2019.
While the 2020 IRS notice is promising, it is now 2022 and this guidance has yet to be released by the IRS. Nevertheless, states have pushed ahead and passed PTE tax legislation.
Kentucky, Indiana, and West Virginia are 3 of the states that tax individual owners’ PTE income with no SALT workaround (yet). PTE owners in these states will still be taxed at the individual level for PTE income. These states allow a tax credit for taxes paid to other states, but they have yet to provide guidance on whether PTET is eligible for this credit.
Ohio is one of the recent states to enact a PTE-level tax. PTEs can elect to pay PTET for tax years beginning January 1, 2022. We covered this new PTE-level tax here.
Tennessee does not have an owner-level personal income tax on PTE income since there is not individual income tax in TN. PTEs pay income (and franchise) tax similar to C-Corporations with no pass-through to PTE owners.
This is a complicated and ever-changing situation creating a tax planning quagmire best navigated by a trusted tax advisor. Please reach out to Blue & Co. for guidance specific to your business.
1 For 2022, the standard deduction is $12,950 for single filers and $25,900 for married filing joint filers