Senate Softens Blow for Pass-Throughs Using Current SALT Workarounds

Thirty-six states use pass-through entity taxes (PTETs) to allow pass-through businesses to avoid the state and local 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. (SALT) deduction cap, but the House’s version of the “One, Big, Beautiful Bill” would have stripped this benefit from legal, accounting, medical, consulting, financial, and other businesses classified as specified service trades or businesses (SSTBs). The Senate, in its language, restores the benefit of these workarounds to all pass-through businesses, while placing new limits on the extent of the workarounds.

Under current policy, pass-through businesses can elect to remit entity-level taxes which provide a credit against 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. liability, essentially avoiding the effect of the $10,000 SALT deduction cap on that income. The House raised the cap to $40,000, though phasing it back to $10,000 for high earners (with the phasedown complete at $600,000 in AGI). Pass-throughs other than SSTBs could continue to use PTETs to avoid the cap, while SSTBs were denied their use and are fully subject to the cap. The Senate retains the existing $10,000 cap but strikes a new balance on the use of PTET workarounds.

Under the Senate plan, income that states tax at the entity level is, for each owner, deductible as follows:

1. Any portion of the $10,000 SALT cap left over for the owner after their personal deductions for other income and property taxes may be deducted for PTE taxes.
2. Above that, the greater of $40,000 or 50 percent of the PTE taxes are deductible.

The Senate cracks down on some states’ practices of using PTETs as a revenue generator. Some states impose higher rates for entity-level taxes, either by taxing all income at a flat rate equal to the top rate of the graduated-rate income tax, or by imposing a separate higher rate. Businesses sometimes elect to pay this higher rate because it yields federal tax savings that exceed the additional state burden, but the Senate does not want the deduction to subsidize higher-than-usual state rates on businesses. After an 18-month transition period, the Senate renders an entity-level tax ineligible for the deduction if it yields more than 102 percent of what an individual with the same taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income.  would owe. The bill text also disallows “substitute payments” under which states might impose some other sort of tax in lieu of their ordinary income tax on businesses electing to make the substitute payment as a way to retain the larger workaround.

The Senate bill follows the House in imposing an anti-abuse penalty for so-called SALT allocation mismatches, designed to prevent partnerships from allocating the PTET’s benefits to partners that are higher than their distributive share of the specified tax payment. This might arise, for instance, if one partner is located in a low- or no-income tax state and thus surrenders their benefit to a partner in a high-tax state, or if one of the partners is a C corporation. This allocation mismatch would draw tax penalties under both the House and Senate bills.

Importantly, non-income taxes on pass-through businesses are regarded as business expenses and are already deductible without regard to the SALT cap, and without the use of PTETs. A business’s payroll taxes, real and personal property taxes, any taxes on capital stock or gross receipts, sales taxes paid by the business on its inputs, and the like are rightly deductible, as they are not part of the owners’ compensation. They are costs of doing business. Only if such a tax were offered as a “substitute” that would offset the owners’ individual income tax liability, essentially recharacterizing income tax payments to work around the new PTET restrictions, could they be denied deductibility.

While the Senate would trim the benefits of PTETs, these workarounds retain a sufficiently substantial benefit that most if not all states currently offering PTETs are likely to continue doing so. The greater certainty about the long-term viability of these elective tax regimes, moreover, may motivate the few remaining holdouts to adopt one. Of states with broad-based income taxes, only Delaware, Maine, North Dakota, Pennsylvania, and Vermont have yet to offer an entity-level tax option. States which tax entities at higher rates would need to realign those rates by the end of the transition period to ensure the continued viability of their workarounds.

In Massachusetts, the credit against the owners’ individual income tax is only 90 percent of the allocated PTET payments, meaning that the PTET rate is functionally 111 percent of what would ordinarily be paid on that income. In Wisconsin, entities pay a flat 7.9 percent rate, which is higher than the state’s top marginal rate of 7.65 percent for all other income. New Jersey has a different rate schedule with higher rates throughout. California pass-throughs pay 9.3 percent on all their income, while Hawaii imposes its pass-through tax at 9 percent, which can be either higher or lower than the amount owed on other forms of income, since both states have graduated rate income taxes with top rates above the PTET rate. And Alabama, Connecticut, Kansas, and Minnesota have graduated-rate income taxes but set the PTET rate equal to the state’s top marginal rate. This is unlikely to be much of an issue in Alabama, where the top rate kicks in at $3,000, rendering it moot for any business with more than $2,040 in PTET payments. Connecticut, Kansas, and Minnesota, however, would run afoul of the new provision without changes.

There has been much debate in recent months about the propriety of business SALT deductions. We have noted in the past that the case for corporate SALT (C-SALT) deductions is strongest. These taxes are imposed on the corporation itself; formulary apportionmentApportionment is the determination of the percentage of a business’ profits subject to a given jurisdiction’s corporate income or other business taxes. U.S. states apportion business profits based on some combination of the percentage of company property, payroll, and sales located within their borders. means that a corporation’s choice of location does not affect its state corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. liability; states separately tax the income distributed from the business; and the deductions do not offset any taxes on the personal income of business investors or employees. (Others have advanced arguments against the C-SALT deduction. Neither the House nor the Senate chose to change the treatment of C-SALT.) At the other end of the spectrum, good arguments for the deductibility of individual taxes are scarce, with the SALT deduction simply subsidizing high earners in high-tax states.

Pass-through businesses are, of course, subject to a range of taxes at the entity level which are appropriately deductible as business expenses, like payroll and property taxes. But these have never been affected by the SALT cap and are not the focus of PTET workarounds. While states are rightly concerned about the effects of high taxes on small businesses, those rates are of course within the state’s control, and PTETs have largely emerged as a way to shield the compensation of 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 from the full brunt of their state’s income taxes. But any increase in business tax liability does come at an economic cost, which is why it is important that any limitation be traded for new pro-growth provisions.

Share this article