Tuesday, January 26, 2021
Walter Hellerstein (Georgia) & Andrew Appleby (Stetson), State Tax Credit Issues Raised by SALT Cap Workaround Legislation, 99 Tax Notes State 211 (Jan. 18, 2021):
For tax years 2018 through 2025, the federal Tax Cuts and Jobs Act of 2017 limited the aggregate amount of itemized state and local tax deductions for federal personal income tax purposes to $10,000. To avoid the impact of this “SALT cap” insofar as it limited the personal income tax deductions of passthrough entity (PTE) owners for federal income tax purposes, several states adopted legislation imposing taxes directly on the PTEs’ incomes. The theory underlying the PTE tax legislation was that state income taxes paid by the PTE would be deductible from the PTE’s income and would correspondingly reduce individual PTE owners’ taxable distributive shares of passthrough income for federal personal income tax purposes without regard to the SALT cap, thereby working around the SALT cap. At the same time, however, to avoid imposing a double state tax burden on individual PTE owners who are now effectively paying state income tax at the entity level, states adopting SALT cap workaround legislation generally provide individual PTE owners with corresponding owner-level tax benefits, in the form of credits, deductions, and exemptions, regarding their state personal income taxes. In essence, the PTE tax legislation simply shifts the incidence of the tax to the entity instead of the individual to circumvent the federal SALT cap imposed on individuals.
After nearly three years of uncertainty over whether the Internal Revenue Service would embrace the theory underlying the states’ SALT cap workaround legislation, the IRS issued a notice in late 2020 essentially recognizing the deductibility of the state PTE taxes at the entity level for federal personal income tax purposes notwithstanding the provisions of the legislation designed to reduce the PTE owners’ state tax liability at the ownership level. The notice declared the IRS’s intent to “issue proposed regulations to clarify that State and local income taxes imposed on and paid by a partnership or an S corporation on its income are allowed as a deduction by the partnership or S corporation in computing its non-separately stated taxable income or loss for the taxable year of payment.”
The notice also recognizes that some jurisdictions “have enacted, or are contemplating the enactment of, tax laws that impose either a mandatory or elective entity-level income tax on partnerships and S corporations” and that “the jurisdiction’s tax law provides a corresponding or offsetting, owner-level tax benefit, such as a full or partial credit, deduction, or exclusion.” The notice further observes that “there is uncertainty as to whether entity-level payments made under these laws . . . must be taken into account in applying the SALT deduction limitation at the owner level.” The notice concludes that the tax payment by the PTE is deductible regardless of whether the imposition of the PTE tax is elective or whether PTE owners “receive a partial or full deduction, exclusion, credit, or other tax benefit that is based on their share of the amount paid” by the PTE “to satisfy its income tax liability” and that “reduces” the PTE owners’ “own individual income tax liabilities” under the state’s tax law. ...
The IRS’s notice recognizing the deductibility of the state PTE taxes at the entity level for federal personal income tax purposes has already spawned considerable interest regarding the issues raised by those levies for state tax purposes. Among these issues are the ability of PTE owners to claim a credit against their personal income tax liability in their state of residence for their distributive share of entity-level taxes paid to other states where the income was earned. We hope that the preceding discussion will facilitate the resolution of these issues in light of the underlying constitutional and policy concerns that we have identified.