SALT deduction
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As of 2018, taxpayers living in high-tax countries are no longer able to deduct state and local taxes above a limit (known as the "SALT" cap) of $ 10,000 per year. This limitation comes from the Tax Cuts and Jobs Act (TCJA) of 2017 and applies to the 2018-2025 tax years. However, the good news is that some states have a workaround, which I'll describe in this post.
On November 9, 2020, the Treasury Department and the IRS issued Notice 2020-75 stating that they "intend to enact legislative proposals to clarify that state and local income taxes paid by a partnership or sub-company levied on their income and paid by it are permissible ". as a deduction by the partnership or S-corporation when calculating their taxable income or loss not shown separately for the taxable year of payment. "
The workaround
To date, state laws for SALT cap workarounds vary, but the general idea is that a pass-through entity (PTE) sets a tax at the state tax rate for individuals. The state then grants the respective owners of the PTE a tax credit on their state income tax return. The SALT cap applies only to individual taxes, not to corporate-level taxes from PTE. Other states subject the PTE to corporate-level tax and then exclude the relevant PTE income from the owner's state tax return.
Check the latest news in your state to see if your state has a workaround for the SALT cap when the tax law goes into effect (i.e. 2021 or 2022) and how it works. For example, Connecticut has made PTE tax mandatory for the SALT cap workaround strategy. Most other states make it optional, which gives the taxpayer more choice; But don't miss the voting deadline. Check with your tax advisor to learn how this strategy can save you money and whether you should consider starting a transit company soon in 2021.
Traders appear to qualify to bypass the SALT cap
Many traders who are eligible for trader tax status (TTS) already use a PTE such as a spouse / partnership or individual member GmbH / S-Corp. TTS traders require an S-Corp to pay compensation to officers to unlock deductions from health insurance and retirement plans that are otherwise not allowed on trading profits that are unearned income.
A TTS trader of stocks, commodities, and other financial products has a business expense treatment. A TTS dealer actively buys and sells capital investments with capital gains and losses or ordinary profits and losses in accordance with Section 475, if selected in good time.
Here's an example: In 2021, Joe Trader will pay $ 35,000 in state income taxes at the S-Corp level with a SALT cap workaround. His S-Corp net income is $ 500,000 and is subject to a 7% state tax rate. Joe hits his SALT cap of $ 10,000 on property tax of $ 11,000, so he loses a $ 1,000 deduction. Joe deducts $ 35,000 in S-Corp state taxes from his gross income and saves $ 12,950 in federal taxes ($ 35,000 tax deduction x 37% of the federal upper marginal tax rate). Without a workaround for the SALT cap, Joe would have $ 36,000 in non-deductible SALT.
Next Steps
Many accountants had taken a wait-and-see approach to the SALT cap bypass strategies as the IRS approval was uncertain prior to the November 2020 IRS notice mentioned above. In addition, the IRS and the Treasury Department previously opposed re-characterizing SALT payments as charitable donations, which some states have attempted.
This PTE tax approach is not alien; some southeastern states use PTE composite returns to determine taxes for non-resident owners.
Some tax experts expected the Biden government to lift the SALT cap. However, President Biden's budget for fiscal 2022 and recent infrastructure laws do not include the lifting of the SALT cap. Republicans in Congress are resistant to TCJA. Some Democrats in Congress said they may not support Biden's infrastructure laws unless they set the SALT cap. Stay tuned!
The PTE tax might be a better solution than the law before the TCJA when SALT was an individual deduction and an alternative minimum tax (AMT) was preferred.
See additional information below:
IRS Signals Company-Level Approval of SALT Cap Workaround, But States Should Still Think Twice (Tax Foundation Nov 11, 2020)
“The Treasury Department and the IRS signaled their intention to bless some sort of government workaround for the $ 10,000 cap State and Local Tax (SALT): corporate-level taxes that allow transit company owners to pay an additional corporate-level state tax. with a credit against their individual income tax liability. As the SALT business tax deduction cap does not apply, this functionally enables these owners to bypass the cap as the corporate tax replaces their income tax payment, which would have been subject to a limited deduction. "
“Connecticut, Louisiana, Maryland, New Jersey, Oklahoma, Rhode Island, and Wisconsin all have corporate taxes in place that can be used to offset the personal tax liability of owners. In Connecticut, corporate tax is mandatory. In the other six states, voting is compulsory; Business owners can choose to pay and claim the loan, or they can decline if it is not in their best interests to go that route. "
California Legislature, Governor Float SALT Cap Workaround Plans (Bloomberg Tax Jan 14, 2021)
“A new California Senate bill (SB 104) would allow pass-throughs – partnerships, limited companies, and sub-companies – to pay corporate income tax that would be fully deductible. The bill does not yet contain a tax rate. Individuals who are members of these companies would exclude the amount that the company pays from their gross income. "
“(Governor) Newsom's proposal is narrower and only applies to S-companies. It would give these companies the option to pay 13.3% income tax instead of the 1.5% California currently imposes on suburban companies. Shareholders would receive a tax credit equal to 13.3% of their on-passed income. Under current California law, the income of an S corporation is also taxable at the shareholder level. "
New York includes workaround for SALT cap in budget deal (Bloomberg, April 6, 2021)
“The deal announced on Tuesday between New York Governor Andrew Cuomo (D) and Democratic lawmakers would allow pass-through companies to pay taxes at the corporate level. The corporate tax would be offset by a corresponding individual income tax credit. "
SALT workarounds spread to more states as Democrats seek repeal (Bloomberg tax dated April 27, 2021).
“Seven states, including California and Illinois, are poised to join nearly a dozen other states like New York and New Jersey that have bypassed the federal limit on state and local tax deductions as the prospect of a state solution remains elusive. New York and Idaho both recently passed laws to circumvent the controversial tax law of 2017 known as the SALT cap. Georgia and Arizona are waiting for their governors to approve similar SALT cap workarounds, and lawmakers in California, Massachusetts, Illinois, North Carolina, and South Carolina are debating similar bills. ”(See the state map of the states included in the workaround are.)
Massachusetts lawmakers force SALT Cap workaround in budget (Bloomberg Tax May 11, 2021)
New York state budget provides a bypass of the federal SALT cap for certain businesses (Forbes, May 27, 2021)
Illinois Assembly Approves SALT Partnership Workarounds (Bloomberg Tax May 31, 2021)
Democrats Consider "SALT" Relaxation for State and Local Tax Withholding (NBC News, June 24, 2021)
Darren L. Neuschwander, CPA, contributed to this blog post.