How are states tackling state tax deduction limit workarounds?

Wolters Kluwer Tax & Accounting looks at the tax use of pass-through entities to avoid the state tax deduction limit.

What: Since the enactment of the $10,000 limit on the deduction of state and local taxes in the Tax Cuts and Jobs Act of 2017, states have been trying to find a way to help their residents get full benefit of the state and local taxes paid on the federal tax return. Early efforts focused on permitting state taxes to be reduced with a corresponding contribution to a state charity. However, the Internal Revenue Service (IRS) position on that approach made the desired result difficult to achieve. 

New York has tried shifting from an income tax to a payroll tax, but many viewed that option as unduly complicated. The IRS has not taken a position on that approach. Connecticut was the first state to enact a statute in response to the Tax Cuts and Jobs Act requiring the state tax to be paid at the pass-through entity level and claimed as a business deduction, although a few states as well as the District of Columbia had pre-existing statutes authorizing pass-through entity level taxation in one form or another. A further half dozen states passed statutes similar to Connecticut’s in 2018, 2019 and 2020, although with elective provisions rather than the mandatory provision enacted by Connecticut. 

Then, on November 9, 2020, the IRS issued Notice 2020-75 stating that the IRS intended to issue proposed regulations clarifying that state and local income taxes imposed on and paid by a partnership or an S Corporation are allowed as a deduction by that entity in computing its taxable income or loss in the year of payment. Notice 2020-75 led ten additional states to enact various forms of the legislation so far in 2021, with another half-dozen actively working on it. 

Why: The state tax deduction workarounds adopted by the states are all different from each other, complicating planning for businesses and their tax advisors operating in multiple jurisdictions. Some of the issues to consider with the state tax workarounds using pass-through entities include the following: 

• The state tax workaround would only be beneficial to taxpayers who itemize deductions 
• The workaround would only be beneficial to taxpayers whose state and local taxes that would qualify for the itemized deduction exceed $10,000 
• The state tax workaround involving pass-through entities would only benefit businesses operating in a partnership or S corporation tax environment, or taxpayers such as sole proprietors who could set up a pass-through entity structure
• The workaround provisions adopted so far are generally an election, although it is currently mandatory in Connecticut
• In some states, the pass-through entity owners receive a credit, in other states an exclusion
• States have different provisions as to the types of pass-through entity owners to which the provision applies and different rules with respect to non-residents 
• The various state provisions involve different tax rates that in some cases may not permit a full offset for the entity owners of the tax paid by the entity 
• States have different effective dates for their statutes, and some states have not yet enacted enabling legislation
• Congress is considering legislation that could modify or repeal the state tax deduction limit, potentially limiting the benefit of these state provisions
• The federal state and local tax deduction limit is already scheduled to expire after 2025 unless Congress takes further action 

Who: Tax experts Tim Bjur, JD, Senior Content Management Analyst, and Mark Luscombe, JD, LL.M, CPA, Principal Federal Tax Analyst, at Wolters Kluwer Tax & Accounting can help discuss the state tax workarounds of the state and local federal tax deduction limit involving pass-through entities. 

PLEASE NOTE: These materials are designed to provide accurate and authoritative information in regard to the subject matter covered. The information is provided with the understanding that Wolters Kluwer Tax & Accounting is not engaged in rendering legal, accounting, or other professional service.

Contact: To arrange an interview with Tim Bjur or Mark Luscombe or other federal and state tax experts from Wolters Kluwer Tax & Accounting on this or any other tax-related topics, please contact Bart Lipinski.