I haven’t written about how the states were handling the SALT (State and Local Tax) Limitations imposed by the Tax Cut and Jobs Act (TCJA) in a while.

And, as I predicted, a slew of states have found ways to help their (richer? more enterprising?) citizens to breach the $ 10,000 limitation. The TCJA changed the way folks could itemize deductions- which meant the percentage of folks using Schedule A dropped from 26% of all taxpayers down to about 10%- and dropping.

Before TCJA, we had personal exemptions of about $ 4000 per soul, and a $ 12,000 standard deduction ($6000 for singles).  The TCJA changed that to no personal exemptions and a standard deduction of about $ 13K (singles) or $ 26K (marrieds).  Moreover, the SALT deduction was limited to $ 10,000.   That means a married couple with $ 10,000 mortgage interest and $ 15,000 (or more) in property and state income taxes and $ 2000 in charitable deductions could no longer itemize.  Because only $10,000 of their SALT could be used on Schedule A.  ($10,000 mortgage interest, $ 10,000 SALT limited, and $ 2000 charity is only $ 22,000; the standard deduction is a better deal for them.  Of course, that’s because they lost out on at least $ 5000 of state and local taxes.)

But not if they reside if one of 14 states (and counting)- and own or are a partner in a pass-through entity (LLC, S Corporation, or partnership).

You see the SALT cap applies to personal tax filings- not to business filings.   Just like businesses can deduct moving expenses (which are no longer deductible for individuals), these entities can deduct state and local taxes paid without limitation.

So, these 14 states (about to become 18 or 20) have set up what is call a PTE (pass-through entity) tax.  Normally, pass-through businesses pay no income tax- all earnings are “passed through” to the owner’s personal tax returns.  And, it’s on the personal earnings that the income taxes are assessed.  (Don’t forget that the TCJA also provides for a 20% reduction in earnings subject to tax, before the pass-through to the owners.)

These states are now assessing state taxes at the business level.  Where they are deductible.  That means the state still obtains the full amount of taxes they expect to collect, but now the business pays them on behalf of their owners.  Which folks couldn’t deduct all their state taxes due to SALT limitations.

There are different ways states deal with this issue.  Some states (like New Jersey) provide the business owners with a credit for their share of the state taxes paid by their companies.  Other states (say Louisiana) reduce the owner’s income by the amount of income upon which their pass-through paid taxes.

New York has a different rule.  (Why are we not surprised?)  The pass-through is allowed to pay the tax; the (graduated to match the income) tax that would apply to the share of profits that is passed to the individual.  But once this election is made- it’s made in perpetuity. One can’t change the rule the next year or the year after that.

Despite the claims that were made when these deals were first being proposed, the IRS is in concert.  The IRS considers these PTE taxes (Notice 2020-75) as if they were imposed on the pass-through entity, making their owners and shareholders exempt from the SALT limitation and fully deductible from income for the pass-through.  The pass-through must have at least two owners (which makes it clear that sole proprietorships are not included in this giveaway).

Et, voila!  These states do not miss a dime of revenue- it’s only the Feds that take the hit.  Further making the TCJA a budget sinkhole.  (It was never revenue neutral; the revenue shortfall has now risen to about a trillion dollars a year.)

What are we talking about?  Well, for every $ 100,000 of state taxes that are paid this way, the Fed doesn’t get to collect something on the order of $ 37,000.  So, if Wisconsin collected some $325 million and New Jersey $1.3 billion, you can get the idea of the dent these 14 states made in the Federal coffers.  (Remember- this is the first year folks in New York will get the chance to play this game.)

Don’t forget that this could affect the surtax the Democrats plan to impose on those earning more than $ 10 million.  After these PTE based taxes will greatly decrease the individual’s federal adjusted gross income.

And, this is a royally inequitable solution to SALT limitations.  If I lived in New York, I would be able to bypass my SALT limitations- but that would not apply to any of my firm’s employees. Or, law firm partners get the benefit while the rest of the office fails to obtain a similar workaround.  And, let’s not forget this greatly benefits those hedge fund and private equity partners- but not one of their employees.

And, then there’s the issue about non-resident partners. If one of the partners lived in New York and the other in Georgia, then only the New York partner gets the credit- while the Georgia partner has his/her revenue reduced to cover the New Yorker’s special benefit.

Not fair at all.  But that’s not stopping anyone.