State and Local Tax Cap Workaround Gets Green Light From IRS

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State and Local Tax Cap Workaround Gets Green Light From IRS

The Internal Revenue Service (IRS) has expressed its intention to support a workaround to the $10,000 restriction on state and local income tax deductions. The proposed rules would exclude partnerships and S companies from the $10,000 limit on state and local tax deductions imposed by the Tax Cuts and Jobs Act. Individual taxpayers who lack such arrangements, on the other hand, will be unaffected.

Key Takeaways

  • Individual taxpayers may deduct up to $10,000 in state and local income taxes on their federal income tax return under the Tax Cuts and Jobs Act.
  • Since the Tax Cuts and Jobs Act was passed in 2017, high-tax states have attempted to find a way around the limit.
  • The IRS has approved a workaround that permits pass-through businesses to avoid the $10,000 ceiling, including S-corporations, certain limited liability companies (LLCs), and partnerships.

State and Local Tax (SALT) Deduction Limit

The Schedule A deduction for state and local taxes (SALT) was formerly unlimited prior to the Tax Cuts and Jobs Act. These taxes are as follows:

  • Real property taxes
  • Personal property taxes
  • Income taxes
  • General sales taxes
  • Taxes on war earnings and surplus profits (these generally apply to industries that profit during periods of war and other crises)

Today, the Tax Cuts and Jobs Act restricts an individual’s deduction for state and local taxes paid during the calendar year to $10,000 ($5,000 if married filing separately). That $10,000 cap might be particularly difficult for persons who reside in states with high income and property taxes.

Looking for Loopholes

High-tax states have been looking for methods to assist people get around the $10,000 restriction since the Tax Cuts and Jobs Act was passed. For example, in 2019, New York, New Jersey, and Connecticut considered legislation that would have enabled citizens to donate money to a state charity fund in lieu of paying taxes, and then deduct the payments as charitable donations on their federal tax returns. The scheme was eventually thwarted by the IRS and Treasury.

  Special Assessment Tax Definition

However, states have lately begun working on another method that employs pass-through businesses to avoid the cap—a workaround that the IRS intends to accept.

What Is a Pass-Through Entity?

A pass-through (sometimes known as a “flow-through”) entity is a legal company entity that distributes profits to its owners and investors. A pass-through entity’s income is taxed solely at the owner’s individual tax rate for regular income; the entity itself is not taxed. Pass-through companies are often utilized to reduce taxes and prevent double taxation.

IRS to Allow Some Businesses to Dodge Cap on SALT Deductions

The IRS has approved a workaround for pass-through companies such as S-corporations, some LLCs, and partnerships. According to an IRS notice, the proposed rules would “clarify that Partnership and S Corporation Specified Income Tax Payments are deductible in calculating their non-separately declared income or loss.”

The IRS notice defines the specified income tax payments as “any amount paid to a State, a political subdivision of a State, or the District of Columbia by a partnership or a S corporation to satisfy its liability for income taxes imposed by the Domestic Jurisdiction on the partnership or the S corporation.”

This implies that S companies and partnerships may deduct specific income tax payments made to state and local governments above the line—rather than as pass-through items for partners and shareholders, where the $10,000 maximum applies.

Most states tax pass-through companies on an individual basis. So far, 13 states have adopted, proposed, or are discussing legislation to tax entities.

“The Department of the Treasury and the Internal Revenue Service are taking the necessary actions to ensure fairness for America’s small companies,” Treasury Secretary Steven T. Mnuchin said in a statement on Nov. 9. “These proposed rules would provide clarification for individual pass-through entity owners.” More states are expected to adopt similar workarounds when the IRS finalizes its standards.

  What Are Some Examples of a Value-Added Tax (VAT)?

The Bottom Line

The IRS’s proposed rules apply to specific income tax payments received on or after November 9, 2020. However, the regulations allow some taxpayers to amend their returns if they made specified income tax payments in a partnership or S corporation’s taxable year after Dec. 31, 2017, but before Nov. 9, 2020—and the payment was “made to satisfy the liability for income tax imposed on the partnership or S corporation pursuant to a law enacted prior to Nov. 9, 2020,” according to the IRS notice.

Whether you operate a small company, consult with a tax expert to see if you qualify for the workaround—and if you need to revise any prior tax returns.

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