Taxpayers have been whipsawed by confusing rules for the $10,000 limit on deducting state and local taxes (SALT), the most politically charged piece of the Tax Cuts and Jobs Act (TCJA) of 2017.1 The cap has caused nearly 11 million individuals to lose an annual deduction worth $323 billion.2 But many owners of private businesses known as passthroughs can avert that financial pain. If you own your company and thus report your business income on your personal federal income tax return, here’s what you need to know.
The $10,000 SALT cap curbed the long-standing ability to fully deduct personal state and local taxes, including real estate and property taxes, on their federal returns.3 For states with no income tax, the SALT cap applies to sales tax. The limit doesn’t apply to rental real estate or investment properties.
Individuals with high property taxes have gotten most of the attention, but the cap is a major sore point for owners of passthrough entities, such as S corporations, limited liability companies and partnerships. Ranging from mom-and-pop stores to privately-held manufacturers to larger partnerships for medical offices, law firms and hedge funds, the entities don’t themselves pay tax. Instead, they “pass through” their income and losses to the individual taxpayers who own the entities, who then report their tax obligations on their personal income tax returns. Not surprisingly, taxpayers in areas with high state taxes or property costs, including California, Connecticut, Illinois, New Jersey, New York, Pennsylvania and Texas, are hardest hit.4 5
Accountants and tax attorneys are happily in the weeds of parsing the benefits and risks of recent federal and state rules that offer ways for both individual taxpayers without businesses and those with businesses to preserve the full SALT deduction. We’ll focus on three strategies for passthrough owners. Keep in mind that the Internal Revenue Service (IRS) has blessed some of the maneuvers. But it hasn’t addressed others, and it’s possible there could be future restrictions.
Strategy #1: Charitable Contributions
Beginning in 2018, Connecticut, New York, New Jersey and Oregon passed laws that said individual taxpayers could make donations to state or local charitable trusts or local municipal funds and local school districts in exchange for a state credit for paying state and local taxes.6 The idea was that under longstanding IRS rules, those taxpayers would get a credit for paying those taxes but also be able to deduct their “contributions” on their federal returns as charitable deductions. No dice, the IRS said in June 2019.7
But earlier, in August 2018, the IRS signaled that it was on board with the strategy if carried out by passthroughs. It “clarified” that “business taxpayers who make business-related payments to charities or government entities for which the taxpayers receive state or local credits can generally deduct the payments as business expenses.”8 By August 2020, the IRS made its “clarification” official.9 It provided a “safe harbor” for passthrough entities, saying that the portion of their SALT payment equal to the amount of the state credit received can be treated by the entity as an ordinary and necessary business expense, instead of as a charitable contribution.
There’s a catch: the safe harbor doesn’t apply to passthroughs if their SALT liability is reduced by the credit. Still, the 2018 clarification spawned an idea: that because the SALT cap doesn’t apply to business taxes, business owners can deduct their SALT payments in full as a business expense on their federal returns. That new workaround is Strategy #2 below.
Strategy #2: Entity-Level Taxes
In May 2018, Connecticut established a mandatory 6.99% levy for passthrough businesses in exchange for what is now an 87.5% credit on their state taxes.10 11 In January 2020, New Jersey passed a law known as the “Business Alternative Income Tax” (BAIT), under which passthrough owners can opt to “reclassify” their state income tax payments as an “elective entity-level tax” ranging from 5.675% to 10.875%.12 Other states, including Louisiana, Maryland, Massachusetts, Oklahoma, Rhode Island, Texas and Wisconsin have enacted similar laws; around half a dozen other states have similar bills pending.13 14
Still, there’s a potential thorn in this workaround.
Remember that August 2020 IRS ruling blessing charitable contributions by businesses? It was silent on the question of business owners paying state taxes at the entity level to generate a business deduction on a federal personal return.15 However, in a recently released notice, the government holds it will allow pass-through entities to fully deduct entity level income tax payments, provided certain requirements are met.16
Strategy #3: C Corporations
The SALT cap applies only to individual taxpayers. C corporations aren’t hit. Given that an S corporation can revoke its S election and return to a C corporation for tax treatment and a limited liability company (LLC) can elect to be taxed as a C corporation, is it worth it to convert? The answer hinges in part upon whether your full SALT deduction is outweighed by the loss of your 20% qualified business income deduction, which applies to pass-throughs but not C corporations.17
Let’s assume you’re married filing jointly and have an adjusted gross income of $170,000 a year from a successful marketing consulting business you own in an LLC. You have property taxes of $15,000 and a state income tax bill of $10,000.
Before the new tax law, you could deduct $25,000 ($15,000 + $10,000) from the total taxable income on your federal return. With the $10,000 SALT cap, you can deduct only $10,000. The non-deductible $15,000 is no longer available to reduce your taxable income, and thus your final federal tax bill.
Assuming you itemize deductions and you’re in the 22% tax bracket, then your additional tax bill due to the SALT cap: $3,300.
Now donate through your business $15,000 to a state charity. Because the IRS considers a business taxpayer’s contributions to be a trade or business expense deduction, rather than a charitable contribution deduction, you preserve the ability to deduct that stranded $15,000, and thus keep that extra $3,300. The income which passes through on the Schedule K-1 would be $15,000 less, resulting in $15,000 lower taxable income, the same result before the TCJA cap was imposed. Voila! You’ve just reduced your tax bill by $3,300.
Keep in mind other line items on individual tax returns are also impacted by the limitation of the SALT deduction. Less itemized deductions means higher taxable income which is tied to the §199a deduction threshold for so-called Specified Service Trades or Businesses which could reduce or eliminate this benefit altogether, again resulting in higher federal tax. Using the passthrough deduction workaround, not only is taxable income reduced (by way of a lower K-1 passthrough income) Adjusted Gross Income is also lower as the reduced K-1 passthrough amount is part of calculating AGI. This can improve other deductions or tax rules limited by high AGIs such as taxable social security benefits, deductible medical expenses, and tax credits.
Say you’re married filing jointly and earn adjusted gross income of $770,000 a year from a successful marketing business. You have property taxes of $15,000 and a state income tax bill of $100,000.
Before the new tax law, you could deduct $115,000 ($15,000 + $100,000) from the total taxable income on your federal return. With the $10,000 SALT cap, you can deduct only $10,000. The non-deductible $105,000 is no longer available to reduce your taxable income, and thus your final federal tax bill.
Assuming you take the newly-doubled standard deduction of $24,800, you’re in the 37% tax bracket. Your additional tax bill due to the SALT cap: $29,400. In addition, since the marketing consulting business is considered a Specified Service Trade or Business, you will not be eligible to deduct the new §199a deduction as taxable income as it is over the joint filing threshold of $426,600.
Now, contrast that with using a C corporation instead of an LLC. In a C corporation, you will pay yourself a reasonable salary, let’s say that is $250,000. You’ll enjoy the benefit of avoiding personal tax on any earnings that remain in the business to help it grow, the ability to deduct all of the state taxes paid, and paying tax at a tax rate of 21%. After your salary is paid, this leaves $500,000 in taxable income in the C corp. You’ll pay federal tax of $105,000 and your state tax, in this case say, $44,20018. Let’s say you retain $100,000 to reinvest into the business, you’ll distribute the remaining cash of $270,80019 as a dividend which is taxed at a 15% qualified dividends tax rate.
By shifting the income to a C corporation, you have preserved the ability to deduct the state taxes of $44,200, reduced your effective tax rate to just 18%, and saved over $34,00020 in federal tax!
With the temporary SALT cap in place until 2026, business owners of passthroughs can potentially boost their bottom line by using one of three workarounds to preserve their full SALT deduction. Understanding the pros, cons and requirements of each strategy is critical. But the reward — thousands of “extra” dollars of “lost” deductions — can provide a welcome boost to the bottom line. Get your tax planner to run the numbers for you today!
1 H.R. 1 (Public Law 115–97, 115th Congress) https://www.congress.gov/115/plaws/publ97/PLAW-115publ97.pdf
2 Treasury Inspector General for Tax Administration, Review of the Issuance Process for Notice 2018-54 https://www.treasury.gov/tigta/auditreports/2019reports/201914019fr.pdf
3 IRC §164(b)(6).
16 Notice 2020-75
17 IRC §199A,
18 Based on California Corporate tax rate of 8.84%
19 $770,000 net income less federal and state tax of $149,200 and retained earnings of $100,000
20 Considers self-employment tax savings and increase in state tax paid of approximately $20,000