The Tax Cuts and Jobs Act of 2017 limited to $10,000 the individual deduction of state and local property and income taxes (SALT). This SALT cap effectively increased individual income taxes on taxpayers working or living in high-tax states. In response to this cap, some states have enacted a workaround for owners of pass-through entities, partnerships and other entities electing pass-through income tax treatment.
The states began imposing an income tax on the income tax of the pass-through entity, such as a partnership, a limited liability company classified as a partnership for federal tax purposes or an S corporation and providing a credit to the owners for tax paid at the entity level. The pass-through entity (not subject to the SALT cap) deducts the state income tax when calculating its taxable income, thereby reducing each owner’s allocable share of the taxable income. On July 16, 2021, Governor Newsom of California signed a bill with a SALT cap workaround effective January 1, 2021. A week earlier, Governor Ducey of Arizona signed his own bill but delayed the effective date to January 1, 2022. Although Governor Baker of Massachusetts signed a budget bill on July 16, he returned the SALT cap workaround provisions to the legislature with a requested amendment. The Massachusetts legislature rejected Baker’s amendment resulting in Baker’s veto of the provision. Because many believe the legislature has sufficient votes for an override, the discussion below addresses the likely conclusion of the bill.
Let’s take a closer look at the three newest SALT cap workarounds.
Massachusetts
Eligible pass-through entities, including S corporations, partnerships, and certain limited liability companies, may elect to pay tax on their income at a rate of 5%. A qualified member of an electing pass-through entity (individual or trust or estate subject to income tax) receives a credit against 90% of the personal income tax imposed on such member’s share of the tax paid by the pass-through entity. Because owners do not receive a full credit for the taxes paid at the entity level, the state believes that the legislation will raise $90 million of revenue in 2022.
Arizona
Eligible pass-through entities, including S corporations, partnerships, and certain limited liability companies, may elect to pay tax on their income at a rate of 4.5%. Owners of the entities receive a credit for the allocable share of taxes paid at the pass-through entity level.
California
Although Governor Newsom originally sought to limit the workaround to S corporations, his administration and lawmakers expanded the option to other types of pass-through entities during final negotiations. For tax years beginning on or after January 1, 2021, qualified pass-through entities may elect to pay a 9.3% entity-level income tax. Owners of the entities receive a credit for the allocable share of taxes paid at the pass-through entity level.
Our Reaction
With the addition of these states, the state tax community has moved to adopting a workaround applicable to a growing number of pass-through entities. We also discussed SALT cap workarounds in a DGC podcast. As states begin drafting regulations interpreting the SALT cap workaround provisions, DGC will closely watch the interpretations of the taxing authorities. In addition, because the Massachusetts provisions will likely limit the credit to 90% of the tax paid at the entity level, you should contact your tax advisor for guidance on the value of the Massachusetts election.
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 / sthomas@dgccpa.com.
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