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July 12, 2021, 12:54 p.m. EDT

14 U.S. states now give the rich this big tax break — and the only loser is Uncle Sam

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By Kim Rueben, Howard Gleckman, and Robert Pozen

While some Democrats are scrambling to convince Congress to repeal the 2017  Tax Cuts and Jobs Act’s (TCJA) $10,000 cap on the state and local tax (SALT) deduction, at least 14 states have quietly found a workaround. 

It helps only a relatively small number of high-income, influential business owners, but  for these taxpayers it can restore much of their SALT deduction. With the cap less binding it could change the way the limit is viewed in Congress.

This effort gives certain residents of these states substantial relief from the cap without costing the states any lost revenue. Unlike past efforts that have been denied by the U.S. Treasury and the Internal Revenue Service, this one appears to pass regulatory muster.

Pass-through businesses such as sole proprietorships, partnerships and S corporations typically are taxed by states and the federal government on their owner’s individual income tax returns. But now, 13 states allow and Connecticut requires some pass-through businesses such as partnerships to pay state income taxes at the entity level rather than on their owner’s personal income tax returns. 

These pass-through entity (PTE) taxes work because the SALT cap applies only to personal income taxes, not taxes paid by businesses. Thus, these business owners can fully deduct state income taxes paid at the business level from their federal taxable income. In other words, the SALT cap does not apply to their partnership income. 

Deep-blue states such as New York and Connecticut are doing this. So are deep-red ones such as Alabama and Louisiana. Besides the 14 states that have adopted the levy, at least four others, including California, are considering the idea. 

States are using one of two models. In New Jersey, for example, business owners get a credit for their share of the tax. In states such as Louisiana, the owners’ state taxable personal income is reduced by the amount of income included on the pass-through’s  return. 

Here is a simplified example: A resident of a state with a 10% individual income tax rate has $1 million in partnership income. She’d normally pay $100,000 in state taxes on that income. But instead, the entity-level approach allows the partnership to pay the $100,000 tax, not subject to the SALT deduction cap. The state still gets its $100,000 while allowing her a tax credit of $100,000 so it doesn’t tax the income twice. Bottom line: She effectively gets to deduct the entire $100,000 from federal taxable income, instead of only $10,000 under the SALT limit.  

While the IRS has disallowed other state efforts to help their residents avoid the SALT cap, it has approved this one. There are some limits, however. The guidance applies only to tax on income earned by the pass-through. Business owners still are subject to the SALT deduction cap on their property taxes or state income taxes on any wages they earn. Because the IRS requires a business to have at least two owners to use the scheme, sole proprietors cannot benefit.

Some business owners still may prefer to pay taxes on their personal income tax returns, especially if partners live in multiple states where the income could be double-taxed if PTEs aren’t in place in some states. 

Some tax lawyers say the IRS guidance allows states to change the form of the tax on pass-through partners without changing the substance, since the amount of state tax they pay is exactly the same whether it is paid by the entity or the owner. No matter, the IRS has blessed PTE taxes, and states are taking advantage. 

The work-around is a win-win for states and many taxpayers. It can save business owners substantial federal taxes without reducing state tax revenue at all. But is it good policy? 

Since corporations already deduct income taxes against their receipts, PTE taxes could be seen as equalizing treatment of the SALT deduction across different types of businesses. 

Yet these entity taxes raise equity issues. Because these states now favor pass-through income over wages, a partner in a law firm, for example, is exempt from the SALT cap on partnership income while her secretary remains subject to the deduction limitation. Similarly, a doctor who is a hospital employee gets no tax relief while a partner in a medical practice making exactly the same income does.   

The federal SALT cap is scheduled to expire at the end of 2025. But as long as it lives, the entity-level work-around is likely to become increasingly popular among states. And why not? The only loser is the U.S. Treasury.    

Kim Rueben is the Sol Price Fellow at the Tax Policy Center; Howard Gleckman is senior fellow at the Tax Policy Center, Robert Pozen is senior lecturer, MIT Sloan School of Management, and senior non-resident fellow at the Brookings Institution. 

More: ‘Trying to strangle local governments’: What happens when states and their cities become adversaries?

Also read: Peter Thiel’s $5 billion Roth IRA moves Congress to consider changes to investment account’s rules

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