Under the 2017 Tax Cuts and Jobs Act (TCJA), the previous administration implemented a $10,000 limit ($5,000 for a married taxpayer filing separately) on federal deductions taken by individuals on their personal income tax returns for state and local taxes paid during the tax year. The recent regulatory updates have led to a substantial increase in federal income tax liability for many people.
Numerous states responded by enacting provisions designed to reverse the financial impact of this limitation on individual taxpayers. California and Illinois are considering joining Alabama, Arizona, Arkansas, Connecticut, Georgia, Idaho, Louisiana, Maryland, New Jersey, New York, Oklahoma, Rhode Island, South Carolina and Wisconsin, by enacting a work around to this limitation for certain pass-through entities.
Before the TCJA, individual taxpayers had no limit on their federal deductions for state and local taxes paid. In November 2020, the IRS approved an arrangement under IRS Notice 2020-75, where a state would impose a mandatory or elective entity-level income tax on partnerships and S corporations. This entity-level income tax would be deductible by the partnerships and S corporations in computing their non-separately stated income or loss. The entity’s tax payment would be reflected in an individual partner’s or shareholder’s distributive pro-rata share of non-separately stated income or loss reported on a Schedule K-1.
The notice stated that indirect owner-level tax benefits wouldn’t be considered when applying the state and local tax (SALT) deduction limitation to the individual partner or shareholder, which basically blessed the related provisions enacted by some states. The IRS limited the arrangement so that it only applies to partners in a partnership and to shareholders of an S corporation.
Both houses of the Illinois Legislature recently passed, SB2531, which would provide for an elective entity-level tax on partnerships and S corporations. By electing to pay tax at the pass-through entity level, the individual owners of these entities would receive a credit against the individual’s personal income tax based upon the tax paid by the entity on the individual’s proportionate share of Illinois net income from the pass-through entity. This irrevocable election would be made on an annual basis and any entity making this election would be subject to the state’s quarterly estimated tax payment requirements.
For non-residents of Illinois, it would also eliminate the requirement to file an individual non-resident return in the state assuming the individual does not otherwise have an Illinois non-resident return filing requirement. Though passed by both houses, as of June 21, 2021, this bill has not become law.
California has also proposed a similar pass-through entity-level tax to work around the $10,000 deduction limitation. California’s proposed legislation provides that pass-through entities eligible for the California election are entities taxed as partnerships and S corporations, which includes LLCs taxed as partnerships for federal and California income tax purposes.
By allowing the pass-through entity to elect to pay tax on net income earned by the entity, California’s SB104 provides a mechanism for the individual owners of the pass-through entity to indirectly deduct state and local taxes paid in excess of $10,000 on this pass-through entity income. As of June 21, 2021, the bill has not been passed by the California legislature.
Fourteen states have enacted SALT cap workaround provisions that materially reverse the federal personal income tax impact of the $10,000 deduction limitation on state and local taxes paid on income from pass-through entities provided the taxpayer meets the statutory requirements applicable to these provisions. Individual taxpayers subject to state and local income tax in these 14 states, whose annual state and local taxes paid exceeds the $10,000 federal cap, may obtain significant benefit from these SALT cap workaround provisions.
Ensuring regulatory compliance can be challenging, as each state has unique and varying requirements. It’s important to discuss your client’s fact pattern with a SALT professional to determine how to best position your clients to maximize their deduction and ensure they don’t pay more federal income tax than necessary. Some SALT cap workaround provisions impose a mandatory tax at the pass-through entity level. As a result, it’s important to understand where your clients may now have entity-level tax liabilities when they previously only had an informational tax return filing requirement in the state.
