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Prior to the enactment of the Tax Cuts and Jobs Act (TCJA) in 2017, taxpayers itemizing their deductions were permitted to deduct state and local tax payments (SALT deduction) from federal income, reducing their federal income tax liability. The SALT deduction reduced the federal income tax liability of high earners. The TCJA capped the SALT deduction at $10,000, $5,000 in the case of a married individual filing separately (the SALT cap).
In a review of the SALT cap, the Tax Foundation, an independent tax policy nonprofit, concluded that most filers benefitted from the TCJA due to lower rates and other reforms. However, some states appreciated the degree to which the uncapped deduction lowered the effective cost of their own taxes, and attempted workarounds to retain the benefit of the SALT deduction.
SALT Cap Workarounds
Initially, the most common strategy was to establish government-linked “charitable” funds, allowing taxpayers to make a voluntary contribution to the state charity (purportedly eligible for the charitable deduction) and receive an offsetting tax credit, reducing state tax liability. However, the IRS concluded that the offsetting tax credit constituted a quid pro quo making the charitable contribution unavailable to taxpayers in these states. Only unrequited charitable contributions constitute deductible expenses. When you receive something in return, the expense is not charitable and not deductible.
Other states adopted a different SALT cap workaround for partners and S corporation shareholders. These states imposed an entity-level tax on the partnerships and S corporations and provided a full or partial credit to partners and S corporation shareholders for the tax paid at the entity level. The entity pays the tax and passes on a distributive share reduced by the tax to its partners or S corporation shareholders.
The IRS’ Thoughts on Most Recent Workarounds
On November 10, 2020, the IRS released Notice 2020-75. This notice announced that the IRS would release proposed regulations to clarify the treatment of the entity-level tax workaround. The notice describes the content of the upcoming proposed regulations and blesses the SALT cap workaround for partners and S corporation shareholders. In other words, the direct imposition of tax on the legal entity itself is not subject to the SALT cap despite the credit given partners and S corporation shareholders and without regard to whether the entity-level tax is mandatory or elective.
As of 12/1, seven states had enacted an entity-level tax as a SALT cap workaround: Maryland, Connecticut, Louisiana, New Jersey, Oklahoma, Rhode Island, and Wisconsin. More states may follow with the release of Notice 2020-75 and the promise of clarifying regulations.
If you have questions about SALT cap workarounds, please reach out to a member of your DGC client service team or Scott Thomas, JD, LLM at 781-937-5172 / email@example.com. You can also visit DGC's coronavirus web page at dgccpa.com/coronavirus which is frequently updated with new resources to help you deal with the financial impact of the coronavirus on you and your business.
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