The 2017 Tax Cuts and Jobs Act (TCJA) brought the most material sweeping tax law changes to Americans in over 30 years. But for some individual taxpayers, the state and local tax deduction (SALT) cap proved to be the most impactful. The provision, which applies to both single filers and married couples filing a joint return, limits the state and local taxes that households can deduct each year from their federal income tax to $10,000. Now, a new tax introduced in 29 states might help select taxpayers sidestep the cap, effectively restoring some of the SALT deduction’s lost benefits.
An Elusive Benefit for High Earners
Combined with the increase in the standard deduction, the SALT cap dramatically reduced the number of taxpayers itemizing deductions. Only about 11% of taxpayers use the SALT deduction, with high-income households realizing most of the benefit. But the SALT cap’s impact on taxpayers varies, largely based on their state of residence.
Prior to the TCJA, state and local tax payments were deductible against regular federal income taxes. Now, under current law, a single filer in California—where the top state tax rate is 13.3%—would exceed the SALT deduction cap after earning about $150,000 ($180,000 for a married joint filer). As a result, for many high-income earners, the TCJA ends up “giving with the right and taking with the left.” Put another way, these taxpayers seem to benefit from a decrease in top federal tax rates, but end up ceding much of the savings back due to the SALT cap.
States Suggest a Workaround
Barring congressional intervention, the SALT deduction cap is set to expire at the end of 2025. In the meantime, several states have implemented workarounds—in the form of a pass-through entity tax (PTE tax) that enables pass-through entities such as partnerships and S corporations (S corps) to avoid the SALT deduction cap.
How does a PTE tax work? At a high level, partnerships, limited liability companies (LLCs) and S corps act as pass-through entities where all income flows through to partners and shareholders. Therefore, income taxes are paid at the partner or shareholder level at personal tax rates rather than at the entity level. Like all other income, pass-through income is subject to the $10,000 SALT deduction cap.
To sidestep the deduction cap, a PTE tax allows qualified partnerships and S corps to pay state income tax at the entity level. Generally, in most states, the PTE tax is elective, although some states have made it mandatory. But why would a taxpayer choose to pay an optional tax? Because PTE tax payments made at the entity level convert what would otherwise be state taxes paid on the personal level into a business expense. The entity can then deduct PTE tax payments against income before it passes through to owners and shareholders.
Converting state taxes into business expenses avoids the $10,000 SALT deduction cap otherwise imposed on personal income. While the SALT deduction cap initially appeared to be an issue only in high-tax jurisdictions, as of Aug. 31, 2022, 29 states have already adopted some form of legislation involving PTE tax. Before exploring special considerations, let’s look at an example of PTE tax in action.
PTE Tax in Practice
Ana is a 50% partner of a California LLC that generated $10 million in total income this year. If the LLC forgoes the PTE tax election, Ana would report $5 million of net income on her federal K-1. Assuming Ana already used the $10,000 SALT deduction on property taxes paid, the full $5 million of business income would be taxable at the federal and state level.
Using a top marginal federal rate of 37%, Ana would owe approximately $1.9 million in taxes. She’d also receive a $665,000 state tax bill, based on California’s top marginal tax rate of 13.3%. Taken together, her total taxes come in around $2.5 million, leaving Ana with $2.5 million of after-tax income.
Now let’s assume the LLC elects to pay the PTE tax, which would equal $930,000 (derived by assessing California’s 9.3% PTE tax on the full $10 million of income). This time, Ana would report $4.5 million of net income ($10,000,000 less $930,000/2) on her federal K-1 and would owe approximately $1.7 million in federal taxes. On her California tax return, Ana would report the full $5 million of net income and a $465,000 ($930,000/2) tax credit against her individual California income tax.
How much has Ana saved? Her state tax bill would decrease from $665,000 to $200,000, while electing to pay the PTE tax brings her personal tax bill down to almost $1.9 million. Ultimately, while less pretax income is distributed to partners, having the entity pay a PTE tax lets Ana keep $3.1 million in after-tax income. That represents nearly a 24% increase in after-tax wealth per partner gained by circumventing the SALT deduction cap.
Does Your Client Qualify?
PTE tax elections can be a powerful tool for owners of partnerships and S corps while the SALT deduction cap remains in effect. But there are some special rules to consider before advising your clients to make the election.
To be eligible for the PTE tax, the entity must have at least two partners; single-owner LLCs don’t qualify. What’s more, rates, eligibility criteria, and personal state tax credits differ by state. For example, in Connecticut, all partnerships and S corps operating within the state must pay the PTE tax. That’s unlike some other states where entities may opt in. Most jurisdictions offer full credit for pro rata portions of a PTE tax paid against the owner’s state income tax, but in some states (like Connecticut and Massachusetts) the credit doesn’t fully cover the state tax paid. And certain states eliminate the credit if the owner resides in a different state from the entity. Making a PTE tax election may also create additional administrative burdens in terms of tracking and reporting.
Importantly, the Internal Revenue Service released Notice 2020-75 on Nov. 9, 2020, announcing its intent to issue clarifying regulations stipulating that state and local income taxes are deductible by partnerships and S corps in computing their non-separately stated taxable income or loss. It remains to be seen whether the same holds true for tiered partnerships and investment partnerships that are generally subject to the miscellaneous itemized deduction.