Continued Developments in the SALT Cap Workaround

by Thu N. Lam, Esq., Chamberlain Hrdlicka | April 10, 2024

As we look to the approaching deadline for the expiration of the federal state and local tax (SALT) deduction limitation on Dec.31, 2025, there does not appear to be any slowdown in pass-through entity tax (PTET) activities from state taxing authorities. It also remains uncertain whether state PTETs will expire with or extend beyond the expiration of the federal limitation.

Recall that prior to Jan. 1, 2018, individual taxpayers who itemized deductions for federal income tax purposes were permitted to fully deduct from income certain state and local taxes paid. In 2017, however, the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, was enacted and included a provision that imposed a limitation on the aggregate amount of state and local property, income and sales taxes that could be deducted and capped such deductions at $10,000 per year (SALT cap). Thus, individual taxpayers who itemized and paid more than $10,000 in state and local taxes could not deduct the excess, unless the taxes were paid in carrying on a trade or business. If Congress does not act to make the SALT cap permanent, the limitation is scheduled to expire. Although there has been debate in Congress to raise the SALT cap, it remains unclear whether the limitation will be extended.

Following the passage of the TCJA, and to help mitigate the impact of the federal limitation on their residents, many states quickly responded by enacting PTET legislations as a workaround to the SALT cap. Under state PTET regimes, eligible pass-through entities, such as partnerships and S corporations, may elect to pay state income tax at the entity level. Under IRS Notice 2020-75, the pass-through entity is not subject to the SALT cap and is permitted to deduct the PTET paid as an uncapped business deduction on its federal return, thereby lowering the ordinary income that flows through to the pass-through entity’s owners. When the owners report income on their state returns, most states require an add-back of state taxes deducted from federal income. Because tax was already paid at the entity level, states with PTET elections generally permit the pass-through entity owners to claim a credit for PTET paid or exclude from income the amount of PTET previously taxed. State PTETs, therefore, effectively provide pass-through entity owners with a complete workaround to the federal individual SALT cap.

As of November 2023, 36 states and New York City all have PTETs in one form or another. Of these 36 states, Hawaii, Iowa, Kentucky, Montana, Nebraska and West Virginia became the latest states to implement their own state PTETs in 2023 alone. In addition, Maine, Pennsylvania and Vermont currently have proposed PTE legislations. 

PTET Expiration Uncertainty

While some states adopted specific effective periods, other states have provided no guidance on the fate of their PTET regimes beyond the expiration of the federal SALT cap. In California, for example, “beginning on or after Jan. 1, 2021, and before, Jan. 1, 2026, qualifying pass-through entities” may elect to pay the state’s entity level tax on income. Under recently enacted legislation in Oregon, the state’s PTET would expire at the same time that the federal SALT cap is set to expire “before Jan. 1, 2026.” In Nebraska, the Department of Revenue recently issued a set of frequently asked questions (FAQs) and clarified that the Nebraska PTET “is not tied to the federal SALT limitation. The PTET election will be available even if the federal $10,000 SALT limitation goes away.” However, in New Jersey and New York, no specific guidance is available regarding the expiration of the state’s PTET. Thus, absent legislation to the contrary, these states’ PTETs would presumably continue following expiration of the federal SALT cap.    

States have also revised legislation or continuously updated their administrative guidance on the mechanics of their PTET regimes. In January 2022, New Jersey Governor Phil Murphy signed Senate Bill 4068 into law (P.L. 2021, c. 419), which made several revisions and clarifications to the Pass-Through Business Alternative Income Tax (BAIT). Effective on or after Jan. 1, 2022, the legislation, among other changes, changed the PTE tax base for partnerships to include all income of a New Jersey resident individual, estate or trust, not just New Jersey-sourced income. BAIT for S corporations, however, continued to be calculated on the S corporation’s New Jersey-sourced income. The legislation also updated the BAIT credit structure and permitted use of such credits, including providing a shareholder, partner or member a credit based on their direct share of tax paid and allowing credits to be applied, for example, as a refundable credit against a PTE’s own tax liability for nonresident withholding tax, minimum taxes and filing fees. For corporations, credits can be applied against the surtax or the corporation business tax.

In Maryland, new procedures for making the PTET election were issued in 2023. In Georgia, FAQs were issued in January 2023 providing guidance on eligibility and treatment of credits. Louisiana also recently added an option for an automatic prospective termination of the PTET election.

So, even with the approaching sunset of the federal limitation, taxpayers should continue to carefully analyze specific state rules to fully weigh whether a state’s PTE election is beneficial.

Thu  Lam

Thu Lam

Thu N. Lam, Esq., is a senior counsel in the state and local tax controversy and planning group at Chamberlain Hrdlicka.

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