How States Are Responding to the SALT Cap Limitation
The Tax Cuts and Jobs Act (TCJA) was signed into law Dec. 22, 2017, and brought an array of changes to the state and local tax (SALT) landscape. One of these changes, commonly referred to as the SALT cap limitation, limits the amount of state and local taxes an individual can deduct on a personal income tax return. Currently, the SALT cap is $10,000 and is scheduled to expire for tax years beginning on or after Jan. 1, 2026.
The SALT cap significantly impacts individuals living in states with high income tax rates, such as California, New Jersey, and New York. In an effort to create a workaround and reduce the impact to residents, states began to enact state-level income tax on flow-through entities. These state-level taxes are commonly referred to as pass-through entity taxes (PTET). To-date, 22 states* have enacted a PTET.
When the PTETs were first enacted, it was uncertain whether flow-through entities would be permitted to deduct the taxes as ordinary business expenses on a federal tax return. The IRS remained silent on the issue until November 2020 when it released Notice 2020-75. While no regulations have been released to-date, Notice 2020-75 informed taxpayers of forthcoming proposed regulations designed to clarify that state and local income taxes imposed on, and paid by, a partnership or an S corporation on its income are allowed as deductions in computing the entity’s non-separately state income or loss for the tax year of payment.
The PTET is a successful workaround to the SALT cap limitation due to the deductibility of the tax. The PTET is an “above the line” trade or business deduction for the flow-through entity rather than a “below the line” itemized deduction at the individual partner level. By treating the PTET as a business deduction, the flow-through’s ordinary income is lower by the amount of the PTET, and, as a result, the partner’s ordinary income on its federal K-1 from the flow-through entity is also lower. Additionally, PTET benefit does not count against the $10,000 SALT cap limitation for individuals.
As with all things SALT-related, the 21 states that have enacted such PTETs have varying degrees of laws and rules. Some of these differences include effective dates of the tax, timing of elections (e.g., during the tax year, by the original due date, or by the extended due date), how to calculate the tax base, and the timing of payments. There are also differences on how the tax and related credit are reported at the individual partner level. Some states include the income from the flow-through entity at the individual level and allow the individual to receive a credit for their pro rata share of the tax paid on their behalf. Other states exclude the income from the flow-through entity at the individual level. Further, states differ on what flow-through entities can make the PTET elections and what partners/shareholders are includable in the calculation.
There are several considerations that need to be taken into account prior to making a PTET election. For example, will a flow-through entity’s owner’s state of residence allow a credit for taxes paid to another state for PTETs? What is the interplay between PTET, composite return filings, and state nonresident withholding? Will composite returns still be permitted, and, if allowed, can the PTET credits be applied against the composite liability? Is nonresident withholding still required if the PTET election is made? What other investments does the taxpayer have?
The available PTET elections may not be beneficial for all taxpayers, and there is speculation that the SALT cap may be modified or repealed by Congress.
To determine whether making a PTET election is truly beneficial, please reach out to your KSM advisor or complete this form.
*States that have enacted a PTET include: Alabama, Arkansas, Arizona, California, Colorado, Connecticut, Georgia, Idaho, Illinois, Louisiana, Maryland, Massachusetts, Michigan, Minnesota, New Jersey, New York, North Carolina, Oklahoma, Oregon, Rhode Island, South Carolina, Wisconsin
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