When the Tax Cuts and Jobs Act of 2018 introduced a new $10,000 cap on state and local tax (SALT) deductions, taxpayers living in areas with high state-level taxes felt the hit. Highly-impacted states like California, Connecticut, Illinois, New Jersey, New York, or Pennsylvania quickly began searching for ways to provide relief to their taxpayers.
Only individual taxpayers filing itemized deductions Schedule A 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.
Three potential workarounds to the SALT cap include:
- 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—if a sole proprietorship, partnership, or S corporation makes a charitable donation, the portion of the SALT payments equal to the state credit received is offset and treated by the entity as an ordinary and necessary business expense.
Entity-Level Taxes
The states whose residents were highly impacted by the SALT cap soon began searching for a workaround. Several determined that if you make a state tax payment through a pass-through business and receive a credit in exchange, that would be allowable as a deduction. 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 levy amounting to 7% of the 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 owners to reclassify their state income tax payments as an elective entity-level tax. That tax 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 tax deduction.
C Corporation
A final workaround is the use of a C corporation, which is not subject to the SALT deduction limitation. 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 in terms of tax treatment. 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, but you will also see double taxation for any amount withdrawn as dividends. 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. If someone is benefiting from the 20% QBI deduction, this would be forfeited if the business converted to a C corporation.
Summary
Taxpayers experiencing higher tax liability since the enactment of the SALT cap may be eager to find a quick fix. 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 gain the expertise you need to advise clients on implementing these workarounds, begin your training to become a Certified Tax Planner today.
