IRS Signals Approval of SALT Cap Workaround
By: Rachel Trickett, Juliya L. Ismailov and Maria Pigna
In Notice 2020-75, released on November 9, the Department of the Treasury and the Internal Revenue Service (“IRS”) announced plans to issue proposed regulations approving one type of state workaround for the $10,000 state and local tax (“SALT”) deduction cap that was imposed by the Tax Cuts and Jobs Act (“TCJA”) in 2017. As explained below, the workaround allows pass-through entities to incur state or local tax at the entity level, with an offsetting state tax benefit to the owners of such entities (for example, a credit against the owners’ individual state income tax liability).
The SALT deduction cap was imposed by the TCJA, limiting to $10,000 (from previously an unlimited amount) the deduction that an individual taxpayer is allowed on a federal income tax return for state and local taxes paid, such as state and municipal income taxes, property taxes and sales taxes. The $10,000 limitation does not apply to taxes that are paid by corporations, however. This puts pass-through entities at a disadvantage because state and local taxes imposed on a pass-through entity’s income generally are not paid at the entity level, but rather by the individual LLC member, partner, or S corporation shareholder. As a result, the taxes that are passed through to the owners are subject to the $10,000 SALT deduction cap.
Since the passage of the TCJA, some state taxing authorities have adopted workarounds to avoid the SALT cap. One example was permitting a state tax credit for contributions to a government-run charitable fund used for state and local government purposes; in final regulations issued in the summer of 2020, the IRS denied a charitable contribution deduction against federal income tax for contributions to such funds. Another workaround, which is the focus of Notice 2020-75, has been enacted in a number states, including Connecticut and New Jersey, but not New York: an entity-level tax is imposed on pass-through entities with a corresponding state tax benefit (for example, a credit in Connecticut) allowed to the owners of the entities. Despite skepticism as to the IRS’s response to this type of workaround, Notice 2020-75 makes clear that this workaround works. Regulations will be promulgated allowing pass-through entities to deduct state and local income tax payments in computing their non-separately stated taxable income or loss for the year of payment. This could lead to more states enacting such state tax workarounds.
The regulations will apply to state and local income tax payments made on or after November 9, 2020. If certain conditions are met, however, the regulations also may apply to tax payments made prior to November 9.
Because the workaround is mandatory only in Connecticut and is elective in other states, the Notice applies whether or not the state entity-level tax is made mandatory or elective. Most states have opted for an elective regime because pass-through entities that are owned by tax-exempt entities, such as charitable organizations and pension plans, do not benefit from the workaround and therefore are not likely to elect to use it.
A word regarding S corporation treatment: A C corporation becomes an S corporation only when pass-through tax treatment is sought by electing S corporation status with the IRS. Although most states and cities honor a valid federal S election, a few states, like New York and New Jersey, require that a separate state election be filed.
More problematic is that some states and cities do not extend pass-through taxation status to S corporations at all, treating them instead like C corporations for tax purposes. These include the District of Columbia, New Hampshire, Tennessee, Texas and New York City. In a state like Texas, double taxation is not a problem because Texas does not impose an individual income tax, so, while tax is paid by the corporation, there is no secondary tax at the shareholder level. However, in other jurisdictions, like New York City, the double taxation problem is ever present. This is because New York City does not recognize federal or New York State S corporation elections. For this reason, New York City residents with S corporation income are always taxed twice by New York City: once at the corporate level and then again on the shareholders’ individual income tax returns, with no credit or deduction available to offset or ameliorate the burden of the double tax.
On a final note, some commentators have suggested that regulations might not be issued at all despite the Notice. The thinking is that a new presidential administration might seek to repeal the SALT deduction cap altogether, leaving the IRS with one fewer TCJA issue to address.
_______________________________________  A pass-through entity is a multi-owner LLC, partnership or S corporation that is not subject to the corporate income tax. Instead, this type of entity reports its income on the owners’ individual income tax returns and taxes are paid by the owners at their individual income tax rates.  In addition to New Jersey and Connecticut, apparently other states who have adopted workarounds are Louisiana, Maryland, Oklahoma, Rhode Island and Wisconsin.