IRS issues approval for SALT cap workaround

Signed into law on December 22, 2017, the Tax Cuts and Jobs Act (“TCJA”) limited an individual’s state and local tax (“SALT”) deduction to $10,000 ($5,000 for someone married filing separately). In response, many states enacted workarounds to this SALT limitation – one such being an entity-level tax on passthrough entities.

In Connecticut, instead of income flowing through to an individual partner or S-Corporation shareholder who would then pay tax, the entity pays the Connecticut tax and the individual receives a share of the corresponding deduction for federal purposes and a tax credit in Connecticut.

Workarounds such as Connecticut’s were fraught with uncertainty.  Would the IRS permit the SALT deduction via the pass-through entity tax, or would it still be limited?  On November 9, the IRS issued Notice 2020-75, which indicated that forthcoming proposed regulations will permit the pass-through entity tax workaround.  The workaround only works for S-corporations, partnerships, and limited liability companies treated as partnerships for federal income tax purposes.

This is certainly a positive development for taxpayers, since Louisiana, New Jersey, Oklahoma, Rhode Island and Wisconsin also recently enacted elective pass-through entity taxes.  Assuming the final regulations are promulgated similarly to those outlined in the Notice, the federal government’s approval of this workaround could lead to entity-level taxes in additional states.

Partners and S-Corporation shareholders receive preferential treatment under the recent IRS Notice.  Wage earners are not able to form an LLC and become a subcontractor rather than an employee in order to take advantage of the workaround.

Mazars’ Insight

Pass-through entity tax workarounds treat pass-through business owners more favorably than a wage earner and it is not immediately clear why.  As a result, states may want to proceed with caution until final IRS regulations are promulgated.  It is important to note that while the workaround may result in a substantial federal change regarding SALT deductibility, it is not likely to materially alter state source income and corresponding state tax liabilities.  

The proposed regulations will apply to specified income tax payments made on or after November 9, 2020.  A specified income tax payment is any amount paid by a partnership or S Corporation to a State, a political subdivision of a State, or the District of Columbia. The proposed regulations will also permit partnerships and S Corporations to apply these rules to specified income tax payments made in a taxable year of a partnership or S Corporation ending after December 31, 2017 and made before November 9, 2020 provided that the specified income tax payment is made to satisfy the liability for income tax imposed on the partnership or S Corporation pursuant to a law enacted prior to November 9, 2020.

Please contact your Mazars LLP professional for additional information.

Published on November 17, 2020

The information provided here is for general guidance only, and does not constitute the provision of tax advice, accounting services, investment advice, legal advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal or other competent advisers.