As Congress Passes SALT, States Look to Intermediate Entities
The Inflation Reduction Act includes a number of provisions dealing with climate change, health care and tax issues. Specifically on the tax front, it imposes a 15% minimum tax on corporations with profits over $1 billion, creates a new 1% excise tax on stock buybacks, and extends the limitation on business losses passed through 2028. But the law does not repeal or increase the $10,000 state and local tax deduction cap enacted by the Tax Cuts and Jobs Act of 2017, or TCJA. Since its passage, high-tax states have lobbied 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) from their federal income. Unsurprisingly, the SALT deduction cap hit residents of these high-tax states the most. In response to the cap, states have begun to implement workarounds in the form of taxes on transmitting entities. These PTETs circumvent the SALT deduction ceiling for members of intermediate entities without impacting the state coffers.
Because these workarounds involve intermediaries, such as partnerships, LLCs, or S corporations, they do not directly benefit W-2 taxpayers and tend to affect some industries more than others. For example, service-oriented industries – like real estate, law, medicine, accounting, etc. – are more often organized in partnerships, while manufacturing, technology and retail tend to be organized in corporations.
Although the validity of these workarounds was initially questioned by some commentators, the IRS blessed them by issuing Notice 2020-75, which states that flow-through entities can claim entity-level deductions. for state income tax when TFWPs are used to shift the tax burden. from individuals to entities. Several states passed TFWPs prior to this advisory, but since its publication, most states have passed these laws.
Although TFWPs vary from state to state, they generally work in the following way: a taxpayer, who is a partner in a partnership (or a member of an LLC or a shareholder of an S corporation) elects to join the TFWP. After that, the partnership pays the TFWP based on its income, with most states adopting a provision that allows the partnership to include the resident partners’ distributive share of income in the tax base.
The TFTE rate is generally the same or similar to the state 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 TFWP the partnership paid because the partnership deducted that 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 grants a personal income tax credit to the partner for the TFWP paid, which results in an effective tax deduction for federal income tax purposes.
Although the TFWP may be able to help flow-through entities, it is certainly not a cure for all taxpayers. Also, the failure to include a repeal of the SALT cap, or at least an increase in the SALT deduction cap, likely means it’s here to stay until at least 2026 when the law expires. Unsurprisingly, most of the push to repeal the SALT deduction cap has come from lawmakers in high-tax states, such as New York and California, whose voters have been hit hard.
However, the repeal of the cap saw strong headwinds. Negotiations over deducting the SALT cap in the Build Back Better bill stalled when some saw it as tax relief for wealthy taxpayers and not politically viable. It therefore makes sense that TFWPs have gained prominence in such high-tax jurisdictions, as they can help a certain segment of taxpayers.
What is surprising, however, is that the TFWPs seem to have fairly broad support in all states, regardless of their political orientation or how their representatives voted to limit the SALT deduction. States like Alabama, Arkansas, Idaho, and South Carolina, whose senators all voted for the TCJA, have adopted their own PTETs. This shows that a broad coalition of states have recognized the problems (i.e. disgruntled voters) that have arisen due to the rather dramatic shift from an unlimited SALT deduction to a capped $10,000 deduction.
It remains to be seen whether the IRS maintains its pro-taxpayer stance expressed in IRS Notice 2020-75, as the agency could change its mind. But given the statement in the notice, such action should be taken prospectively, as the IRS generally honors its published guidelines. It has publicly stated that it will not take a position adverse to a taxpayer who has relied in whole or in part on public advice until more formal regulatory procedures are enacted.
Even if the IRS attempted to revoke Notice 2020-75 and challenge the TFWP plans, it would almost certainly face legal challenges. States are sovereign and can impose their tax structures as they see fit – they are not even bound by federal treaties, although most abide by them. We would also expect the IRS to fend off such a challenge or try to find ways around the effects of TFWPs.
While states have already taken matters into their own hands by enacting TFWPs, 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 expires in 2026. Given the political climate Currently, it seems unlikely that a repeal of the SALT deduction cap will make its way through Congress until they are forced to act.
Until then, taxpayers will have to scramble to determine the organizational structure that will benefit their business the most. Since the TCJA also reduced the federal corporate tax rate to 21%, the new law just extended the pass-through business loss limit. With most states having already adopted TFWPs, 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 views of the Bureau of National Affairs, Inc., publisher of Bloomberg Law and Bloomberg Tax, or its owners.
mike sheikh is a partner in Baker McKenzie’s Los Angeles office. He handles administrative audit and appeal files, as well as legal proceedings on various tax issues. He also provides tax advice on yield positions, reorganizations, mergers and acquisitions, and other transactions.
david pope is a partner in the New York office of Baker McKenzie. 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 a partner in the Chicago office of Baker McKenzie. He advises on tax planning in the areas of international and real estate taxation, including US and international clients.
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