Should you be pursuing the SALT cap workaround?
- Importance of talking to your tax advisor
- What is the SALT cap workaround?
- What states does that workaround apply to
- Example of how it works in New York
- How to know if this is for you
- How to do this – talk to your tax advisor
The SALT cap workaround is not well understood by most pass-through entity owners, and as a result it is underutilized. If you are the owner of a pass-through entity such as a business and are seeking to reduce your tax liability, here are some tips for how to leverage the SALT workaround. And by the way, we realize that most writeups on this topic are written in “CPA-ese” – which we try not to speak when trying to explain esoteric tax concepts to the public.
Before we get into the blog, we are financial advisors in Philadelphia serving clients across the country. We have written other blogs clarifying tax issues such as the following, which you may wish to read:
We’d also like to remind you that we are not offering tax advice in this article. Our statements are general in nature. For specific recommendations applicable to your situation, consult yourtax advisor
Now for the feature presentation – all about the SALT cap workaround.
What is the SALT deduction?
First if all, what is a tax deduction? A tax deduction is an expense that gets subtracted from your taxable income, thus lowering the amount of tax you pay. Deductions can be a variety of things, from charitable donations to IRA contributions and mortgage interest.
SALT stands for “state and local tax.” Basically, you can deduct up to $10,000 of:
- State and local property tax
- State income tax or sales tax
You claim these taxes as an itemized deduction on Schedule A (Form 1040), Itemized deductions of your Federal tax return.
Note that you can either deduct your income tax or your sales tax, but not both. If you live in a high-income tax state such as New York, deducting income tax would make sense. If you live in Texas where there is no income tax but there is sales tax, you would opt for the latter.
What is the SALT workaround?
The Tax Cuts and Jobs Act of 2017 (TCJA) limits individual deductions taken on the Federal return by individuals. The deduction limit is $10,000 for tax years 2018 to 2025.
However, it does not limit such deductions incurred through business activity. As a result, there is a loophole for business owners, individuals who own pass through entities: entity-level income taxes for passthroughs.
Touche!
Certain states can elect to allow pass through entities (such as corporations and partnerships) to have state income taxes directly imposed on business entities, instead of passing through to the individual. This is deemed a “pass through entity tax” (PTET).
So why do all this?
What is the advantage of passing through income tax to an associated entity, such as a business, rather than paying it outright as an individual?
The benefit is that paying taxes at the entity level effectively reduces the amount of income for the pass-through entity that the owner has a share in. The person, in turn, is liable for a lower amount of tax on the income for the entity.
Who this may apply to
The workaround does not apply to W-2 wage earners or individuals; the SALT workaround applies to owners of pass through entities. The idea has become popular with owners of S Corporations, partnerships, entities taxed as partnerships, family offices, investment partnerships, and even some statutory trusts and sole proprietorships.
Also, please note that the SALT workaround is only available in certain states. You can only claim the SALT workaround if your state allows. If you are a resident of one state, you can not claim PTET credit to another state where you have a residence.
As per FORV/S, the states that have adopted PTET programs as of November 2021:
- Alabama
- Arizona
- Arkansas
- California
- Colorado
- Connecticut
- Georgia
- Idaho
- Illinois
- Louisiana
- Maryland
- Massachusetts
- Minnesota
- New Jersey
- New York
- North Carolina
- Oklahoma
- Oregon
- Rhode Island
- South Carolina
- Wisconsin
Example of how it works
Let’s take the case of Keira, a New York City business owner. She owns an LLP and files her taxes as a limited partner, with business entity taxes being passed through to her as an individual. She itemizes deductions on her Federal income tax return.
For the year 2021, she files and pays her federal, state, and local taxes. The state and local deductions are $15,000, but because of the SALT cap, she can only utilize $10,000 of the $15,000 deduction.
How does she effectuate the SALT cap workaround?
- Keira receives an individual deduction for $5,000 of state and local taxes when she files her partnership tax return.
- The Federal government then issues the LLP a deduction of $5,000.
- The LLP’s income is reduced by $5,000.
- The amount of tax owed by Keira for the LLP income that she receives is reduced.
Please note that in this case, Keira is the sole owner of the LLP and didn’t need to obtain consent from other owners. However, were there multiple owners, consent would be needed for all of them.
Should you pursue the SALT cap workaround?
As a reminder, nothing in this article can be construed as tax or financial advice. For such matters, please consult with a CPA.
There are many details to consider if one is thinking about try to participate in a PTET program utilizing the SALT cap workaround. It is compulsory to understand what the tax effects are, for both the owners of the pass-through entity and also the entity itself.
It is also useful to remember that the future of this initiative of highly uncertain. While the cap is set to expire in 2025, it’s unclear whether Congress will increase it, extend it, or pursue another course of action. There is no clear guidance on the direction at this time.
We advise all owners of passthrough entities who qualify to tread lightly and devote significant attention to staying apprised on developments, if this is something you wish to pursue.
We are financial advisors in Philadelphia, advising high net worth clients across the country on financial and tax related matters regarding their personal wealth or their businesses. Please contact us if you have questions you wish to discuss.
Sources
IRS. Topic No. 503 Deductible Taxes. Retrieved from here.
Ramsey Solutions. (9 May, 2022). How Does the State and Local Tax Deduction Work? Retrieved from here.
Scheutz, Jeff, Sparlin, Rhonda, and Kuntz, Amie. (2022, April 6). Bloomberg Tax. State Passthrough Entity Taxes and Federal SALT Cap Considerations. Retrieved from here.
Ludman, Adam, McGraw, Tom, and Sprechman, Jordan. JPMorgan Private Bank. Can you benefit from the SALT Cap workaround? Retrieved from here.
Wheeler, Josh. Forvis. (3 January, 2022). Get Up, Work Around, & Throw Out the SALT – State Tax Entity-Level Elections for Pass-Throughs Summarized. Retrieved from here.