No, we aren’t talking about preserving meat. But we are talking about preserving money. Yours.
Astute followers will recall when the 2017 TCJA was enacted it limited the ability of individuals to deduct as an itemized deduction State and Local Taxes (SALT) to a maximum of $10,000. In high tax states such as California that was a bitter pill for most everyone filing a “long form” since the property tax on a new $800,000 home would likely be almost that much alone. The income taxes withheld for state purposes and other local assessments typically drove this amount much higher, and the loss of these deductions resulted in increased Federal income taxes for many.
When the change was enacted there was much howling and gnashing of teeth from high tax state politicians who portrayed this as politically driven. In California and other states, legislators hatched theoretically challenged workaround schemes to try and circumvent the law, most of which were promptly (and rightly) shot down by the IRS.
But, as Bob Dylan would say, “the times they are a changing”.
The IRS recently released Notice 2020-75 which lays out an approach for how partnerships and S corporations that pass through their taxable income to owners can deduct the state income taxes on behalf of the owners. This is great news for partners in partnerships, LLC’s, and shareholders in S corps. It will require state legislation that allows qualified businesses to elect to pay state tax at the entity level on the entity’s business income. It then becomes a deduction against Federal taxable income. The tax paid by the entity results in a state tax credit that is passed to and claimed by the owners. This was the only version of workaround to the SALT cap that wasn’t expressly barred by the IRS, and it has now been officially blessed.
The key here is it requires specific state legislation to allow businesses to elect to pay the state income tax on the business’s income at the entity level. With at least half a dozen states already having such legislation on the books, where does California stand?
Que the crickets.
California currently has no such legislation on the books that will allow this.
The IRS notice says that regulations will be forthcoming which should provide a clear roadmap to successfully enable partners and shareholders to deduct state taxes against their business income. Hopefully the legislature in Calif will quickly pick up the ball and run with it at that time. In the meantime, affected taxpayers in states with existing legislation and who made such elections may amend their returns and apply for refunds back to 2017.
It will be interesting to see how many sole proprietorships and independent contractors suddenly decide to become S corps and partnerships when the regulations are released. My prediction is that this is the camel’s nose under the tent. When business owners get the deduction, wage earners will start raising their hands asking why they aren’t entitled to the same treatment. And why should a husband-wife partnership get the benefit but a Sole proprietorship does not? For that matter, why should a partner in a partnership in Oklahoma pay less Federal tax than the same partner/partnership in California? It will be a matter of fairness at that point.
And soon to be President Joe Biden, in his tax platform, has stated he wants to eliminate the SALT cap anyway.
I think it’s just a matter of time.