If there’s a hint of the theatric in states’ efforts to enact workarounds to the new $10,000 cap on the state and local tax deductionA tax deduction is a provision that reduces taxable income. A standard deduction is a single deduction at a fixed amount. Itemized deductions are popular among higher-income taxpayers who often have significant deductible expenses, such as state and local taxes paid, mortgage interest, and charitable contributions. , New York is well on its way to fielding a repertoire company. It may not have the most colorful cast of characters – that Falstaffian honor arguably belongs to California for its short-lived “golden state coin” idea – but what it lacks in panache, it makes up in variety. In case two workaround strategies weren’t enough, the playbill now has a third feature: an entity-level tax on pass-through businesses, designed to 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. the owners of unincorporated businesses at the business level (where state taxes are fully deductible) rather than at the individual level (where they are now capped at $10,000).
The emergence of a third SALT cap workaround in New York demonstrates a distinct lack of confidence that the primary approach – recharacterizing taxes as charitable contributions – will fly. If officials believed their contributions in lieu of taxes strategy would work, they wouldn’t have to bother with much more convoluted payroll taxA payroll tax is a tax paid on the wages and salaries of employees to finance social insurance programs like Social Security, Medicare, and unemployment insurance. Payroll taxes are social insurance taxes that comprise 24.8 percent of combined federal, state, and local government revenue, the second largest source of that combined tax revenue. and, now, entity-level tax alternatives.
A “discussion draft” on the creation of an unincorporated business tax, circulated by the New York Department of Taxation and Finance, follows in the footsteps of a similar law just adopted in Connecticut, but many questions remain. Before we get into those, though, here’s the basic outline of the proposal:
Under current law, 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. es (S corporationAn S corporation is a business entity which elects to pass business income and losses through to its shareholders. The shareholders are then responsible for paying individual income taxes on this income. Unlike subchapter C corporations, an S corporation (S corp) is not subject to the corporate income tax (CIT). s, partnerships, LLCs, and sole proprietorships) are not subject to an entity-level tax, unlike C corporations, which pay corporate income taxes. Instead, their income passes through to owners, who report it on their 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. forms (ownership-level taxes). In order to extend a SALT deduction cap avoidance option to pass-through business owners in the event that the charitable contribution recharacterization scheme fails, New York officials propose to change all that.
Although unincorporated businesses don’t pay entity-level taxes almost by definition – hence the term “pass-through” – New York would upend those rules by imposing a 5 percent tax on the New York-apportioned income of select unincorporated businesses (LLCs and partnerships, but not S corporations), then providing an individual income tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. valued at 93 percent of the amount paid under the new unincorporated business tax.
Consider a two-partner company with $400,000 in New York income, equally shared. For simplicity’s sake, suppose that both partners already have income from other sources, so all their income from this partnership is taxed at both the federal (37 percent) and New York (8.84 percent) top marginal rates.
Under current law, each has $200,000 worth of 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. and owes an additional $17,680 in New York income taxes. Under the proposal, the company pays $20,000 in unincorporated business taxes, and each partner receives a credit reducing their state tax liability by $9,300, meaning that their total taxes to New York are $18,380 each (more than previously), but their individual income tax liability is $8,380. The other $10,000 each is (theoretically) fully deductible for federal tax purposes, whereas the deduction would have been disallowed previously (our hypothetical taxpayers are already above the $10,000 cap). At the top marginal federal income tax rate, that’s a savings of $3,700, for net savings (after higher New York taxes) of $3,000.
| Current Law | Proposal | |
|---|---|---|
|
Partnership Income |
$200,000 | $200,000 |
|
Entity-Level Tax |
$0 | $10,000 |
|
State PIT Liability |
$17,680 | $8,380 |
|
Total State Liability |
$17,680 | $18,380 |
|
SALT Deduction Savings |
$0 | $3,700 |
|
Net of Federal-State Liability |
$17,680 | $14,680 |
That’s how it works in theory, at least. Professor Daniel Hemel of the University of Chicago Law School, who has defended the viability of New York’s other SALT cap workarounds (conclusions with which this author disagrees), has questioned whether the entity-level tax approach would succeed. Certainly, business taxes are fully deductible, but the Internal Revenue Code regards all income from pass-through businesses to be subject to the individual income tax and imposes the $10,000 cap on all “state and local, and foreign, income, war profits, and excess profits taxes,” among other taxes.
Professor Hemel maintains that the entity-level tax is still an income tax, and that the deduction flows through Schedule K-1 (for the business) to the individual owner’s 1040 and is claimed there. This means that a pass-through business does not have the ability to deduct the tax at the entity level because the federal code does not countenance entity-level taxation of such businesses. For federal purposes, it’s all individual income.
Now the calculation looks worse. The taxpayer in the above example is down $700 – the premium paid to New York – without any federal tax savings. There are, moreover, further complications which stem from an entity-level tax imposed on income generally subject to an individual income tax.
Imagine a firm with partners in New York and New Jersey. A New Jersey-based partner who conducts some of the firm’s business in New York will owe taxes to both states. Typically, she would be able to take a credit against her New Jersey income tax liability for any income taxes paid to the state of New York, but since, in this case, she would remit most of her New York taxes in the form of entity-level unincorporated business taxes, she would not be able to avoid double taxationDouble taxation is when taxes are paid twice on the same dollar of income, regardless of whether that’s corporate or individual income. of that income by reducing New Jersey tax liability commensurately.
Now imagine a New York-based partner at the same firm. The partners’ income tax liability, or some substantial share of it, is converted into an entity-level tax, with a corresponding credit to reduce income tax liability. No provision exists to pay only the share associated with New York-based owners, or to allocate the credits to New Yorkers, so some share of the New York partners’ benefits is lost to those in New Jersey, who can’t do anything with it.
And that’s not all. The discussion draft requests input on critical details:
- The rate. The discussion draft includes a rate of 5 percent, which is less than the tax liability incurred under New York’s current individual income tax structure for anyone with taxable income in excess of $23,500. A higher rate, however, could mean that a greater share of taxpayers face higher liability under the new entity-level tax—not even taking into account the fact that the credit only offsets 93 percent of the amount paid. Credits can be carried forward indefinitely, but are not refundable, so if taxpayers “overpay” at the entity level, they cannot necessarily immediately make up the difference on their individual income taxes.
- The base. The discussion draft uses federal ordinary business income as the tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. , but asks for comment on more exotic options akin to what New York uses in its needlessly complex 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. . It expressly raises the possibility of a franchise tax with two or three alternative bases, such as a capital stock base or an alternative minimum tax component. If, as advertised, the goal of the entity-level tax was merely to help taxpayers get around the new SALT deduction cap, these provisions would not be necessary.
- The exemptions and opt-outs. The New York Department of Taxation and Finance asks for input on whether income under a certain threshold should be exempt, or whether the tax swap should be optional, like the new payroll tax swap. Both questions again bely the notion that the proposal is merely intended to reduce taxpayers’ federal liability. If that were the only state interest, there could be no possible harm in making the system optional, and if the proposal were universally beneficial, there would be no point in an income exclusion.
- The taxpayer classes. Currently, the proposal would only apply to partnerships (including LLCs), though the Department asks whether it should be expanded to cover S corporations as well.
The proposal is, in short, a mess—an academic exercise that would make the state’s tax code even more convoluted, exacerbate compliance costs for small businesses, increase tax liability for some, and create headaches and introduce inequities for businesses with owners or income in multiple states. And it may not even achieve its stated purpose.
Connecticut recently adopted a similar law, with similar shortcomings. Grasping at every possible way to let highly-compensated taxpayers get around the new SALT deduction cap makes for terrible tax policy. This approach represents a fundamental change in how many unincorporated businesses are taxed; that’s the sort of change that should be made carefully, if at all. At least New York, unlike Connecticut, is asking interested parties how to improve the proposal. Here’s one idea:
Don’t do it at all.
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