A growing number of states are offering pass-through business owners a workaround for the $10,000 federal deduction limit for state and local taxes, known as SALT.
A controversial part of Republicans’ 2017 tax overhaul, the SALT write-off cap is costly for filers who itemize deductions and can’t claim more than $10,000 for property and state income taxes.
The limit has been a burden to those in high-tax states, such as California, New Jersey and New York. While there has been a push to repeal the law, President Joe Biden hasn’t included the measure in his proposals.
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Although the IRS and Treasury have blocked some individual strategies to bypass the cap, some states have created a workaround for pass-through businesses, such as partnerships, S-corporations and some LLCs.
The IRS issued guidance on these state-level tactics in November 2020, offering the green light to certain businesses.
More than a dozen states have passed legislation to approve the workaround, including Alabama, Arkansas, Arizona, California, Colorado, Connecticut, Georgia, Idaho, Louisiana, Maryland, Minnesota, New Jersey, New York, Oklahoma, Rhode Island, South Carolina and Wisconsin, according to the American Institute of CPAs.
There is pending legislation in Illinois, Massachusetts, Michigan, North Carolina, Oregon and Pennsylvania, AICPA said.
While the maneuver may offer tax savings for some business owners, it may not be the right move in all cases, financial experts say.
“The devil’s in the details,” said certified financial planner Sharif Muhammad, founder and CEO of Unlimited Financial Services in Somerset, New Jersey.
How the tax on pass-through businesses works
Most U.S. companies are pass-through businesses with profits flowing to owners’ individual tax returns.
The new bypass typically involves a state levy on these businesses, allowing the company to cover part of the owner’s state income taxes.
The pass-through business typically pays the levy. But while some states allow a deduction at the entity level, others offer a credit for taxes paid.
For example, last week, Gov. Gavin Newsom of California signed a law allowing some businesses to pay an extra 9.3% levy on each owner’s share of the company’s net income.
Owners who participate may then claim a credit on their California tax return equal to the 9.3% tax.
“You’ve effectively prepaid your state taxes on your pass-through income,” said Perry Ghilarducci, a CPA and partner at Avaunt Ltd. CPAs & Consultants in Sacramento, California.
Not right for all businesses
The workarounds may seem like a welcome relief for business owners shelling out tens of thousands of dollars in property and state income taxes every year.
However, it’s critical to crunch the numbers before making any moves, Muhammad said.
A business owner needs to review their taxes at the entity and personal level, he said. For example, if they don’t itemize deductions, the benefits may not be as significant.
Moreover, a business owner in a lower tax bracket may overpay their state levies for the year, Ghilarducci said.
“The numbers have to be laid out, and everybody has a different situation,” Muhammad added.