By: Jamie Baker, CPA
Key Takeaways:
- The Tax Cuts and Jobs Act of 2017 created a lot of complexity due to its SALT deduction limitation, disproportionately affecting taxpayers in high-tax states.
- In response, 36 states (including Illinois) have enacted “SALT workaround” laws allowing PTEs to deduct state and local taxes at the entity level, circumventing the federal limitation on individual deductions.
- Three more states are considering similar legislation, and nine states have no owner-level personal income tax on PTE income.
- Making the PTE election may make sense for some taxpayers depending on various state rules.
- These state laws sunset with other TCJA provisions on Dec. 31, 2025; Congress could extend them beyond this date. Some have specific expiration dates associated with them, such as Illinois’ law, which is scheduled to expire on December 31, 2026.
Six years after passage of the Tax Cuts and Jobs Act (TCJA) of 2017, one of its least popular provisions has resulted in complex new tax laws offering state-level tax relief to pass-through entities (PTEs) in a majority of states.
The TCJA imposed a $10,000 limit on the amount of deductions taxpayers could claim for taxes paid to state and local governments. The state and local tax (SALT) deduction limitation disproportionately affected taxpayers in states with high taxes and high property values. In response, innovative state tax laws that allow pass-through entities (PTEs) to deduct state and local taxes at the entity level, helping to mitigate the SALT limitation, have been enacted in most states.
To date, 36 states (including Illinois) have enacted so-called “SALT workaround” laws, all of which broadly follow the model of shifting deductibility of SALT taxes from the individual to the PTE entity. The significance is that the PTE is not subject to the $10,000 deduction limitation at the federal level.
Besides the 36 states that have enacted these laws, three additional states are considering similar laws. Of the remaining states, nine have no owner-level personal income tax on PTE income, and two others have neither introduced nor passed legislation.
PTEs Not Subject to SALT Limitation
Under these new state tax laws, PTEs such as partnerships, S corporations, and LLCs can elect to pay state taxes at the entity level, rather than at the individual owner level. The PTE can then deduct these state taxes as a business expense, which is not subject to the SALT limitation, effectively sidestepping the federal limitation on individual deductions. The remaining income reported to the individual owners is reduced, resulting in a lower federal tax liability.
These state tax laws have drawn praise for their ability to circumvent the federal SALT deduction limitation while providing a lifeline to businesses and individuals who might otherwise consider moving to lower-tax states to minimize their tax liability.
However, there are some complexities and potential challenges associated with these laws. For instance, in states that have enacted PTE-level deductions, individuals may have to navigate the interaction between their state and federal tax obligations carefully.
For many taxpayers, it may make sense to make the PTE election in one state but not in another, depending on various state rules. Key factors to consider in determining if you will utilize the PTE election include:
- In some states, the PTE election is mandatory for owners, or is mandatory for certain types of taxpayers such as non-residents.
- In other states, use of a composite return is mandatory.
- States often have different rules regarding the PTE election depending on whether a non-resident filer has no other source of income in that state.
- Certain states address tiered partnerships differently, with some factoring in the distributive amount of income to the PTE income.
- In certain states, if taxes are paid at the entity level the credits are not passed through to the entity’s members. Since the tax is at the entity level, the credits remain at the entity level. This will be a key consideration in whether to make the PTE election.
These Laws Will Sunset – Maybe
One important consideration in long-term tax planning for PTE owners is that the SALT deduction limitation is scheduled to expire on December 31, 2025, along with other significant TCJA provisions. Many of the state PTE laws that were enacted to work around the SALT limitation include language that calls for them to expire automatically if the federal SALT limitation expires.
However, some have specific expiration dates associated with them, such as Illinois’ law, which is scheduled to expire on December 31, 2026. It is possible that Congress will act between now and 2025 to extend the SALT deduction limitation, or not. It is too early to tell which of the TCJA’s many expiring provisions will be allowed to disappear into the sunset. While there are complexities associated with these state PTE laws, they represent a proactive response by state governments to address the unintended consequences of federal tax reform.
If you have questions about whether you should utilize the PTE election, either in your home state or any other state in which your pass-through entity does business, contact your KRD tax advisor.
