Among the many important changes to the Tax Cuts and Jobs Act 2017 (TCJA), individual taxpayer deductions for state and local taxes (SALT deductions) on Federal Form 1040, Schedule A, have been capped at $ 10,000 ($ 5,000 for married taxpayers filing separately). The “SALT cap” results in reduced itemized tax deductions for individual taxpayers, which particularly impacts homeowners who pay property taxes on their homes and employees subject to state and local income taxes.
Of course, the expanded “standard deduction” has benefited many taxpayers, but may not have produced enough net benefits, especially for taxpayers residing or working in high tax states.
In the aftermath of the TCJA, several states immediately began looking for ways to get around the federal SALT return cap limitation.
To date, more than a dozen states have amended their tax laws to replace personal income tax on their business income (subject to the SALT cap) with a corresponding income tax imposed on flow-through business entities ( i.e. partnerships, limited liability companies corporations taxed as partnerships and S corporations), which tax is paid and deducted at the entity level and therefore not subject to SALT ceiling.
The Internal Revenue Service effectively sanctioned the workaround, for appropriately designed flow-through entity taxes (PTE), in IRS Notice 2020-75.
As always, tax laws vary in each state depending on their specific statutes. The relevant provisions include:
- Whether the PTE tax in a state is optional (most states) or mandatory (for example, Connecticut);
- When the choice is made (and if it can be revoked); and
- If or when the estimated PTE taxes must be paid, among other matters.
More importantly, taxpayers should carefully consider whether the after-tax federal benefit outweighs the state-specific PTE tax (a PTE tax may be imposed at the highest marginal income tax rate or deny unreimbursed professional expenses to a partner or to a shareholder owner).
Finally, most states anticipate that their PTE tax is not available when the federal SALT cap expires under the TCJA in 2025 or if federal tax laws are changed before 2026, which may increasingly become a possibility. , further complicating tax planning and compliance for business owners. .