IRS Issues Guidance on SALT Cap Workarounds

  • Tax strategies
  • 12/16/2020
business man team discussion

A new IRS notice effectively permits owners of pass-through entities to deduct certain state and local taxes (SALT) on their federal income tax returns in excess of the $10,000 SALT cap.

Key insights

  • The Federal Tax Cuts and Jobs Act imposed a $10,000 cap on the deduction for SALT for individual taxpayers.
  • Many owners of multi-state pass-through entities can no longer deduct SALT they paid on an individual basis that were passed through to them from the business.
  • The IRS will accept the deduction of entity-level taxes on the individual owner’s federal income tax return.
  • Owners of pass-through businesses will still have federal deductibility limitations on much of their SALT, because individual taxes computed at the business level and passed through to the owners are still limited.

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The IRS released Notice 2020-75 on November 9, 2020, which effectively allows state and local tax (SALT) workaround deductions for individual owners of pass-through entities (PTEs). Since the $10,000 federal income tax deduction limit for SALT was implemented by the Tax Cuts and Jobs Act, several states — including Connecticut, Louisiana, Maryland, New Jersey, Oklahoma, Rhode Island and Wisconsin — have passed laws that impose an entity-level tax on a PTE, but allow individual owners of these entities to claim a credit for this tax on their individual state of residence taxes. Review how this new guidance may impact you.

Indirect deductions

These entity-level taxes create an indirect deduction — they are imposed on the business, which means they are deductible at the business level and thus reduce the taxable income flowing through to the individual. While many taxpayers and tax preparers have been claiming these deductions, this new clarifying guidance from the IRS reduces uncertainty and indicates that the IRS will not challenge the deduction of these entity-level taxes on the individual owner’s federal income tax return (provided that the draft guidance is finalized).

Clarifying the relationship between entity- and individual-level tax

The taxes subject to this notice function as a hybrid between entity-level tax and individual-level tax — they are imposed at the entity level, but also allow for a credit against the owners’ state tax liability in their state of residence. This guidance clarifies the treatment for these taxes imposed on the entity. This guidance only applies to entity-level taxes and does not change the federal treatment of the pass-through income. The net tax liability generated by taxable income and state income tax credits passed through from the entity remains subject to the $10,000 SALT deduction cap for federal income tax purposes. As a result of the Notice, however, the amounts subject to the SALT limitation will be less.

For many multi-state business owners (unless more states change their laws to enact similar regimes), the majority of the state taxes generated from business activity remain an individual tax liability, subject to the SALT limitation. In the wake of this guidance, more states may consider changing their laws. The effect on multi-state tax liabilities, as to whether a resident owner receives a tax credit for taxes paid to another state, remains unknown.

How we can help

This notice may impact your state and local tax deductions. Our CLA tax professionals are here to help you navigate this new guidance and identify ways you may need to adapt. Connect with us today for assistance.

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