Individuals should view SALT cap workaround with caution

| 11/12/2020
Individuals should view SALT cap workaround with caution

In Notice 2020-75, the IRS announced that it will allow above-the-line deductions for state tax workarounds on pass-through entities. Following enactment of the $10,000 cap on state income tax deductions for individuals under the Tax Cuts and Jobs Act of 2017, some states enacted new tax structures for pass-through entities that impose state income tax directly on pass-through entities rather than on the individual owners. These pass-through entity tax structures typically are paired with a credit for the individual owner on pass-through income for the tax paid by the pass-through entity.

Under the notice, the IRS will treat state income taxes directly imposed on pass-through entities as a business expense of the pass-through entity. The expense is not subject to the $10,000 limit, even if the individual receives a credit for the tax paid by the pass-through entity on his or her personal return.

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While this is welcome news from a federal income tax standpoint, it could pose unintended consequences for individuals subject to state income tax as nonresidents. In most states, individuals are subject to tax on all their income, regardless of whether it is attributable to their state of residence. In addition, in states where income is earned by a pass-through entity, income tax will be imposed on the owner based on his or her share of the income attributed to that state. To mitigate the impact of the same income being taxed twice, the state of residence will provide a tax credit. Because the credit is predicated on the individual being subject to tax in the nonresident state, it might not be allowed for taxes imposed on the pass-through entity itself. For example, most states do not allow a credit for the Tennessee income-based tax imposed on most pass-through entities because the owners are not subject to tax. It remains unclear whether a state similarly would disallow a resident credit for an elective pass-through entity tax.

The notice indicates that the guidance applies to tax payments made in the partnership or S corporation’s taxable year ending after Dec. 31, 2017, and made before Nov. 9, 2020, provided that the payment is made to satisfy the liability for income tax imposed on the partnership or S corporation under a law enacted prior to Nov. 9, 2020.

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