Ever since the Tax Cuts and Jobs Act of 2017 placed a cap on the amount of state and local taxes (SALT) you can take as itemized deductions on your individual tax return, high-income earners have found themselves paying more federal tax. And though some congressional leaders fought hard to repeal the $10,000 SALT cap recently—threatening to withhold their support for the Inflation Reduction Act (IRA) unless it included SALT reform—in the end they agreed to vote for the IRA even though it left the cap unchanged.
What does this all mean for you as a business owner?
If you’re a partner or shareholder in an LLC or an S corporation, you may be able to take advantage of state-level SALT workarounds and reduce your tax liability.
How States Are Approaching the SALT Cap
The cap on itemized SALT deductions is due to expire at the end of 2025, unless legislators move to repeal or change it sooner. Until then, it limits you to taking up to $10,000 in state and local taxes as itemized deductions on your individual federal income tax return. If you live in a high-tax state, that figure probably represents only a portion of your total state and local tax liability—causing you to pay higher federal taxes than you would have without a cap on the deduction.
Not long after the SALT cap was imposed, legislators in some states tried to institute measures to allow individuals to bypass the cap, but the IRS and Treasury Department rejected those efforts. Then in late 2020, the IRS released guidance that allowed state pass-through entity tax (PTET) workarounds to the SALT cap for individuals who own partnerships, S corporations, and certain types of LLCs.
In states that have since adopted a PTET workaround, a pass-through entity can pay state taxes on business income rather than pass that tax liability onto the individual partner or shareholder. This in turn enables the individual to take any remaining state and local tax deductions—such as property taxes or state tax on non-business income—on their personal tax return, maximizing the deductions allowed under the cap.
To date, at least 23 states have instituted SALT workarounds and others are likely to follow suit.
What State PTETs Look Like
While the overall concept is the same, each state’s PTET workaround works slightly different. Let’s look at the specifics of two states as examples: California and Colorado.
California passed a PTET workaround bill in November 2021, called the Small Business Relief Act, then expanded it in February 2022 to include previously disqualified entities, including those with partnership or federal disregarded entity owners. Each qualified owner of the pass-through business entity makes its own election to participate in the PTET; it isn’t necessary for all qualified owners to agree to make the election. For any partner or shareholder who makes the election, the business entity can pay the state tax on the owner’s share of the business’s net income. Shareholders who elect to have their tax paid by the entity receive a credit against their California state income tax liability, with any excess credit available to carry over for up to five years.
In Colorado, the SALT Parity Act went into effective for tax years beginning on or after January 1, 2022. As in California, owners of S corporations or partnerships in Colorado can elect to have the state tax on their share of the business’s income paid at the entity level, enabling them to use any remaining SALT deductions on their individual tax return and reduce their federal tax liability. The legislation was modified recently to allow owners to make retroactive elections back to tax years beginning on or after January 1, 2018. To take advantage of this new provision, partners and shareholders must make their retroactive election on or after September 1, 2023 and before July 1, 2024, and the entity must file a composite amended tax return accordingly.
Before You Elect to Take a SALT Workaround…
As with any opportunity to reduce your tax liability, there are always implications to consider.
For instance, if you have income in more than one state it’s important to work with an experienced tax advisor to understand whether you’ll save money by electing into the SALT workaround or whether you might end up paying more state tax as a result. That could happen if one of the states you do business in has enacted a SALT workaround and another hasn’t, which could cause you to lose the associated tax credit for tax paid to another state.
It’s also important to know whether your state includes guaranteed payments and other income allocations in the taxable base, which could impact your tax liability, and whether your state allows a full credit on your individual tax return for tax paid at the entity level (which isn’t the case in all states).
These are just a few of the many implications to consider before you elect into a SALT workaround.
How Simple Startup Can Help!
The CPAs and other tax professionals at Simple Startup provide proactive tax planning guidance and tax services that range from managing year-end tax filing to providing ongoing tax and accounting advice and support. Our Tax Advisory services help you get ahead of your tax obligations, stay tax audit-ready, and ensure you’re never paying more tax than you should. And our Tax Returns/Compliance services dig deep into your business and industry to ensure we maximize your deductions, minimize your tax liability, and reduce your stress over tax-related issues.
Schedule a call to find out whether a state-level SALT workaround could benefit your partners and shareholders or to learn more about Simple Startup’s comprehensive tax planning and preparation services.