One of the more fascinating aspects of the 2017 Tax Cuts and Jobs Act concerns the limitation on deducting state and local income taxes. Prior to the enactment of the TCJA, state and local income taxes were fully deductible when computing federal tax liability. The TCJA capped that deduction for individuals at $10,000. In itself the cap was not particularly remarkable. There are innumerable sections in the Code that cap deductions at some arbitrary amount. What was fascinating about the SALT cap was the politics involved. The TCJA cap primarily strikes at the wealthiest taxpayers: the vast majority of individuals pay much less than $10,000 in state and local income taxes. One might therefore expect that, were there to be any political bickering on the issue, it would be the Democrats who would fully support the cap and the Republicans who would resist. It did not play out that way. The highly contentious measure was proposed by the Republicans and fiercely denounced by the Democrats. The reason for this seeming reversal of the usual political positions was pure partisan politics: blue states tend to have higher income taxes than red states (the only states with top marginal rates higher than 10% are California, New York, and New Jersey).
In this week’s feature article, Professor Daniel Hemel describes how states have attempted to bypass the SALT cap by enacting pass-through entity taxes (PETs).
Pass-through entities are entities, such as partnerships and S corporations, that are not subject to tax at the entity level. Instead, the partners or shareholders report and pay tax on their proportionate share of the entity’s income. Under a typical PET, entities that are ordinarily pass-through may elect to pay tax on their income. Partners and shareholders are then entitled, depending upon the specific statutory regime, either to exclude from taxable income their proportionate share of the entity’s income on which tax was already paid or to receive a credit for tax paid on the entity level. The idea is to shift the state income tax liability from the individual partner or shareholder to the entity and thereby to avoid the SALT cap which, recall, applies only to individuals. An additional benefit of the PET regime is that state and local taxes would be deductible “above the line” instead of “below the line.”
Sounds good. The only trouble is that it doesn’t work. As Professor Hemel explains, this is due to the distinction made by the federal pass-through tax regime between “non-separately stated” and “separately stated” items. As noted, Partnerships and S corporations are not subject to federal tax on their income. Instead they prepare Schedule K-1 information returns which indicate each owner’s share of the entity’s tax items. Non-separately stated items are tallied together at the entity level, with the net amount included in the information return. Separately stated items are, as their name indicates, stated separately. As a rule, an item must be stated separately if the use of that item depends upon the partner’s or shareholder’s particular tax situation. Thus, for example, ordinary and necessary business expenses are tallied at the entity level, while capital gains and losses are separately stated.
Meticulously analyzing the statutory text and the legislative history, Professor Hemel proves that, following the TCJA, state and local income taxes must be reported as separately stated items on the information return. Consequently, the deduction by individual partners and shareholder of state and local income taxes paid by the entity is subject to the $10,000 cap.
Nevertheless, in Notice 2020-75, the IRS determined that income taxes paid by pass-through entities are non-separately stated items that may deducted at the entity level. The adjectives used by Professor Hemel to describe this Notice include “astonishing,” “surprising,” “wrong,” and “outrageous.” It not only amounts to a multi-billion-dollar giveaway to the wealthiest Americans, but also creates inequity between pass-through owners and wages earners.
Hemel goes on to speculate about the politics surrounding Notice 2020-75. As the Notice was issued under the Trump administration (although six days after the 2020 presidential elections), he suggests that it was an attempt to curry favor with wealthy pass-through owners, who are a powerful constituency within the Republican party. The question that he then raises is why President Biden, who has consistently called for the wealthiest Americans to pay their fair share of taxes, has acquiesced to the Notice, when he could at any time have simply “picked up the phone and asked his Treasury Secretary or IRS Commissioner to reverse Notice 2020-75.” Here, too, Professor Hemel ventures that it is partisan politics at work. Rescinding the Notice would anger Democratic members of Congress who represent high-income districts in New York, New Jersey, California (several of those members have called on the IRS to keep the Notice in place and have even called on Congress to prevent the IRS from using appropriated funds to issue regulatory guidance that restricts the deduction of state income taxes paid on the entity level). Furthermore, if some sort of relief from the SALT cap is required in order to garner support for his big-ticket spending programs from moderate Democrats who represent high-income districts in the Northeast and California, Biden would prefer that the budgetary cost of removing the cap be scored as low as possible, and the estimated revenue loss depends upon the current-law base-line. Allowing the pass-through entity workaround to stay in place reduces the estimated cost of any statutory relief from the SALT cap.
Professor Hemel concludes by calling on the IRS to rescind Notice 2020-75 immediately: “Swing-district Democrats may grumble, and the budget math on President Biden’s long-stalled Build Back Better legislative package may become somewhat more complicated, but the President, the Treasury Secretary, and the IRS have a duty to enforce the law, and Notice 2020-75 reflects an abdication of that duty…. The longer the notice remains in place, the more revenue will pour out of the federal government’s coffers and into the pockets of high-income passthrough owners – all without statutory authority.”