The Internal Revenue Service or IRS recently signaled it intends to endorse a workaround to the $10,000 cap on state and local income tax deductions in a taxpayer-friendly development. On state and local tax deductions enacted under the Tax Cuts and Jobs Act, the proposed regulations will allow partnerships and S corporations to skirt the $10,000 cap. However, I won’t help individual taxpayers who lack such structures.
– Individual taxpayers can deduct a maximum of $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 enacted in 2017, high-tax states have tried to find a way around the cap.
– The IRS recently allowed a bypass that allows passthrough entities, including S-corporations, some limited liability companies (LLCs), and partnerships, to skirt the $10,000 cap.
State and Local Tax (SALT) Deduction Limit
The Schedule, A deduction for state and local taxes (SALT), was unlimited before the Tax Cuts and Jobs Act. These taxes include:
– Real property taxes
– Personal property taxes
– Income taxes
– General sales taxes
– War profits and excess profits taxes (these generally apply to industries that profit during periods of war and other crises)
Currently, the Tax Cuts and Jobs Act limits an individual’s deduction to $10,000 ($5,000 if married filing separately) for the aggregate state and local taxes paid during the calendar year. And thus, that $10,000 limit can be problematic, especially for those who live in states with high income and property taxes.
Working Around The $10K Cap
The high-tax states have looked for ways to help taxpayers get around the $10,000 cap ever since the Tax Cuts and Jobs Act was enacted. For instance, in 2019, Connecticut, New Jersey, and New York proposed legislation that would have allowed residents to give money to a state charitable fund in place of taxes—and then deduct the payments as charitable contributions on their federal tax returns. Although, the IRS and Treasury ultimately blocked the strategy.
However, recently, the states have been working on another option, which uses passthrough entities to dodge the IRS plans to approve the cap-a workaround.
A Passthrough Entity
A legal business entity that passes the income on to its owners and investors is a passthrough, also known as a “flow-through” entity. Whatever income generated by a pass-through entity is taxed only at the owner’s tax rate for ordinary income, which means the entity itself is not taxed. To limit taxation and avoid double taxation, passthrough entities are commonly used.
IRS Will Enable Some Businesses to Dodge Cap on SALT Deductions
For pass-through entities, including S-corporations, some LLCs, and partnerships, the IRS recently green-lighted a workaround. According to a notice issued by the IRS, the proposed regulations will “clarify that Specified Income Tax Payments are deductible by partnerships and S corporations in computing their non-separately stated income or loss.”
Keep in mind that the IRS notice defines the specified income tax payments as “any amount paid by a partnership or an S corporation to a State, a political subdivision of a State, or the District of Columbia to satisfy its liability for income taxes imposed by the Domestic Jurisdiction on the partnership or the S corporation.”
That means the S corporations and partnerships can deduct the specified income tax payments paid to state and local governments above the line – and not as passthrough items for partners and shareholders, where they would be subject to the $10,000 limit.
Most state tax pass-through entities at the owner level, and now, 13 states have enacted, proposed, or considered laws that would tax the entities themselves.
Another important point to keep in mind is that the workaround does not apply to single-member LLCs and sole proprietorships.
In a November 9 statement, Treasury Secretary Steven T. Mnuchin said, “The Department of the Treasury and IRS are taking the necessary steps to provide fairness for America’s small businesses,”
“These proposed regulations will offer clarity for individual owners of pass-through entities.”
Once the IRS finalizes its regulations, more states will likely consider similar workarounds.
Specified income tax payments made on or after Nov. 9, 2020, apply to the proposed regulations described by the IRS. Nonetheless, the regulations make room for some taxpayers to revise their returns if they made specified income tax payments in a taxable year of a partnership or an S corporation after Dec. 31, 2017, and before Nov. 9, 2020—and according to the IRS notice, if the payment was “made to satisfy the liability for income tax imposed on the partnership or S corporation according to a law enacted before Nov. 9, 2020,”
It would be wise to ask your tax professional if you qualify for the workaround, if you are a small business owner and whether you should amend any previous tax returns.
At UBOS, our experts are always available to guide you with anything related to tax planning, tax strategies, and more. Do contact us today at ubos.pro to begin your consultation and learn more about how we can help you!