IRS Signals Approval of Entity-Level SALT Cap Workaround, But States Should Still Think Twice

In proposed regulations released this week, the Department of the Treasury and the Internal Revenue Service (IRS) have signaled their intention to bless one type of state workaround for the $10,000 State and Local Tax (SALT) deduction cap: entity-level taxes that allow owners of pass-through businesses to pay an additional state taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. at the business level, with an offsetting credit against their individual income tax liability. Since the SALT deduction cap does not apply to business taxes, this functionally allows these owners to avoid the cap, since the entity-level tax substitutes for their income tax payment, which would have been subject to a capped deduction.

State income tax codes typically allocate business income from pass-through firms on to the owners’ individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. returns. An entity-level tax assesses a liability directly on the firm before the income passes to the owners, much like a corporate income tax. Connecticut, Louisiana, Maryland, New Jersey, Oklahoma, Rhode Island, and Wisconsin have all adopted entity-level taxes which offer credits against the owners’ personal tax liability.

In Connecticut, the entity-level tax is mandatory. In the other six states, it is elective; business owners can choose to pay it and claim the credit, or may decline if it is not in their best interest to go that route. There are several reasons why it might not be. While states offer credits for taxes paid to other states (to avoid double taxation), the credits are tied to income taxes and often won’t apply to taxes recharacterized as entity-level payments. If one or more of the business partners reside out-of-state, moreover, partners who have little or no liability in the state itself will still have to pay the entity-level tax but won’t have an in-state income tax burden to offset, leading to double taxationDouble taxation is when taxes are paid twice on the same dollar of income, regardless of whether that’s corporate or individual income. .

The IRS and Treasury previously rejected state efforts to help their taxpayers avoid the SALT deduction cap by recharacterizing their tax payments as “charitable contributions” to the state. But here, despite some grounds on which the scheme might have been rejected, the proposed regulations permit the entity-level treatment and decline to treat the income as flowing through to the individual owner for federal income tax purposes.

The federal government’s approval of this workaround—assuming the final regulations are promulgated—could lead to similar entity-level taxes in other states, but there’s good reason for states to stop to take stock. The provisions complicate state tax codes; entity-level taxes cannot approximate individual income tax codes very effectively, as they are designed for different purposes and with different structures. Such provisions, moreover, treat pass-through businessA pass-through business is a sole proprietorship, partnership, or S corporation that is not subject to the corporate income tax; instead, this business reports its income on the individual income tax returns of the owners and is taxed at individual income tax rates. owners more favorably than other earners, and it is not immediately clear why an investor in an S corporation, or a member of a partnership, should receive preferential treatment compared to someone who earns her income through wages instead.

Wage earners cannot, moreover, form an LLC and become a subcontractor rather than an employee to gain the benefit of the deduction. The workaround can only succeed for S corporations, partnerships, and LLCs treated as partnerships for federal income tax purposes. Owners and investors in these businesses stand to benefit in some cases (though far from all); other taxpayers do not.

Historically, states have not been eager to bog down their own tax codes with convoluted provisions designed to help a small subset of their taxpayers reduce their federal tax liability. If states are concerned about their competitiveness for business owners, they would be better served by looking inward rather than further distorting their tax structures and complicating taxpayers’ returns through SALT cap workarounds.

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