How To Beat The $10,000 Deduction Limit On State Taxes (SALT)

August 2022 ISSUE August 1, 2022
Tax Individual
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Congress capped the itemized deduction for state and local taxes at $10,000 as part of the 2017 Tax Cut and Jobs Act with two motivations. First, to reduce the effective subsidy for high tax states whose governments could raise taxes with the federal government absorbing some of the costs through larger itemized deductions for its residents. Second, Congress also wanted to raise taxes to help pay for lowering individual tax rates. 

That law change spurred a growing migration of high-income taxpayers out of Democratic leaning high-tax states (particularly New York and California) into Republican leaning no income tax states (e.g., Florida and Texas). Democrats in the high-tax states opposed the cap and sought to overturn it in court, or repeal it through legislation, but those efforts failed.

States eager to attract (and retain) high income taxpayers have quickly been passing legislation that effectively circumvents the $10,000 cap for business owners operating as Subchapter S corporations or partnerships (including LLCs). These are known as Pass-Through Entities (PTE), since their net income isn’t taxed at the business level, but rather passes through to be taxed on the owners’ personal return.

For business owners, the chance to lower their federal tax bill is attractive, while state tax collections remain largely unaffected. So far, 29 states* have passed the workaround provisions, converting business owners’ personal state income taxes into deductible business taxes that escape the SALT cap, and the remaining states that impose income taxes are rapidly joining in. Ironically, the Trump administration blessed the workaround with Treasury Department Notice 2020-75 issued shortly after the 2020 election, and the Biden administration hasn’t yet acted. According to a recent Wall Street Journal analysis, business owners participating are already saving over $10 billion in federal income taxes a year because of these workarounds.

How It Works

In these workarounds, states create new taxes which are paid by the PTE and are subtracted from the net income otherwise reported by the business owner. Then the owners get credit on their personal state income tax return for having paid the taxes already. The net effect is a full deduction for the state income taxes paid by the owners on their federal tax return, says Jonathan White, CPA**, specializing in tax and accounting services for high-income doctors.

For example, if you report $500,000 in annual profits from your Subchapter S corporation, you can have your S corporation calculate and pay the state income taxes due thereon, based on your state income tax rate. Assuming a 7% rate, the $35,000 in state income taxes owed would be paid by the practice (not you), while you would receive credit for that payment when you file your personal state income tax return. If you’re in the highest federal income tax bracket (37%), the workaround would save you $12,950 a year in federal income taxes ($35,000 x .37=$12,950).

Make The Election

White says this move is NOT automatic in most states. Rather, you must have your CPA elect to make the Taxed PTE election or you won’t be able to take advantage of this tax saving opportunity. While most states allow the election to be made when you file your practice tax return, others (i.e., California) require an election by mid-year. So, contact your CPA now to make this election for your 2022 practice tax returns, if you haven’t yet done so.

*These include California, Oregon, Idaho, Utah, Arizona, Colorado, New Mexico, Kansas, Oklahoma, Arkansas, Louisiana, Mississippi, Alabama, Georgia, South Carolina, North Carolina, Virginia, Minnesota, Wisconsin, Illinois, Michigan, New York, Massachusetts, Rhode Island, Connecticut, New Jersey, Missouri, Ohio, and Maryland.

**For more information on Jonathan White, CPA’s comprehensive dental accounting and tax compliance services, call 704.288.1731.

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