Among its many changes, the Tax Cuts and Jobs Act of 2018 introduced a new limitation on state and local tax (SALT) deductions. The new $10,000 cap has primarily impacted taxpayers living in areas with high state-level taxes like California, Connecticut, Illinois, New Jersey, New York, or Pennsylvania. These states quickly began searching for ways to provide relief to their taxpayers.
Only individual taxpayers using Form 1040 Schedule A (used for itemized deductions) are affected by this limitation. State taxes, property taxes, and personal property taxes are limited to $10,000 in deductions, but taxes for C corporations and rental and investment properties are not impacted. In states that have very low or no state taxes, the SALT cap applies to sales tax and property tax.
Impacted taxpayers should consider these three potential workarounds to the SALT cap:
- Charitable contributions
- Entity-level taxes
- C corporations
Charitable Contributions
Taxpayers can receive a state or local tax credit when they make a voluntary charitable donation to a state or local charitable trust, a local municipal fund designated as charitable, or a local school district. This can offset any state or local taxes owed—the only problem is the charitable contribution limit. In order to receive a deduction, the taxpayer must first subtract the value of any financial benefit received. For example, if you participated in a silent auction fundraiser, you would need to subtract the value of the item you purchased from the amount you spent, and any amount remaining would be deductible.
In August 2020, the IRS officially provided a safe harbor allowing taxpayers to count their donation as a deduction. The one exception is in the case of a pass-through entity, such as a sole proprietorship, partnership, or S corporation. If these businesses make a charitable donation and receive a tax credit, the amount of SALT payments covered by that credit is treated as an ordinary and necessary business expense, so this will need to be reflected on their corporate tax returns.
Entity-Level Taxes
The states whose residents were highly impacted by the SALT cap soon began searching for a workaround. Several determined that owners and partners of a pass-through business could pay their state taxes through that entity and receive a state tax credit in return. These taxpayers would also be allowed to take a business deduction for taxes paid. This created the pass-through entity tax (PTE).
Connecticut was one of the first states to enact a PTE tax in 2018. The state required a new 7% levy on the pass-through entity’s business income, and in exchange, the taxpayer received a state tax credit covering 87.5% of taxes due. Similarly, New Jersey passed the business alternative income tax (or BAIT) law in 2020, which allowed pass-through business owners to reclassify their state income tax payments as an entity-level tax, which ranged from 5.675% to 10.875%. In both situations, the states created an avenue for taxpayers to satisfy their state tax requirement in a way that still allowed for a business tax deduction.
C Corporation
A final workaround is the use of a C corporation, which is a business type that is not impacted by the SALT cap. To rescue their state income tax deductions, businesses should evaluate if it could be worth filing as a C corporation. When an S corporation revokes its S election, it automatically reverts to a C corporation from a tax perspective. An LLC can simply elect to be taxed as a C corporation without changing its business type.
To determine if it is worthwhile to convert your business, consider these factors:
- The ability to manage double taxation. A C corporation is subject to a 21% tax rate on its profits, but when the company also distributes profits to its shareholders, those dividends are taxed again at the individual level. This may actually create more tax than the business is currently paying, even after salvaging the state tax deduction.
- The qualified business income (QBI) tax deduction. Eligible self-employed and small-business owners can deduct up to 20% of their qualified business income on their tax returns. If a taxpayer is benefiting from the QBI deduction, this would be forfeited if the business converted to a C corporation.
Summary
While Congress continues to debate about the future of the SALT cap, impacted taxpayers may be eager to find a solution today. For some taxpayers, a simple workaround could result in rescuing most of their SALT deductions, while for others a workaround may not be viable or may result in the loss of other important benefits. To determine if a SALT cap workaround could be a solution for you, reach out to a Certified Tax Planner today.
