For some business owners, sidestepping the $10,000 cap on the state and local tax deduction can trigger more tax bills.
Bypasses to the curb in states including Connecticut and New Jersey provide legal ways for business owners to preserve their full deduction, which includes those often-steep property levies. But some shocked taxpayers can wind up owing more tax than they originally would have.
“There are instances in which using a workaround isn’t worth it,” says Bruce Ely, a tax lawyer at Bradley Arant Boult Cummings in Birmingham, Alabama. “You have to model this thing carefully.”
One of the most controversial elements of the 2017 Republican tax overhaul, the SALT (state and local tax) cap has applied to all individual taxpayers since 2018. As financial advisors routinely hear, clients especially feel its sting when they live in expensive places. For example, residents in Atherton, California, America’s second-wealthiest zip code, according to Bloomberg, pay a median $71,000 in property taxes, on top of state income taxes that top out at 13.3%.
Bloomberg News
There’s no way for ordinary individuals to avoid the SALT curb, after the Treasury Department shut down several creative proposals in 2019. But for business owners, workarounds are now in place in 7 states and are under consideration by other states, including New York, California and Minnesota. The snag: the workarounds, blessed by Treasury last November, typically benefit only those with business income from the state where they actually live — say, a Connecticut resident who owns a local landscaping firm.
By contrast, taxpayers who live in a state that’s not where their business is located “can wind up paying state taxes in both states,” says Howard Wagner, a CPA and Partner of National Tax Services at Crowe in Louisville, Kentucky.
Here’s what financial planners can tell their clients
The SALT cap bypasses are designed to boost business owners who run their businesses through partnerships, S corporations, and other entities called passthroughs. Such businesses don’t themselves pay tax; instead, they channel their taxable profits or losses to their owners, who then report them on their individual returns, where they get caught by the cap.
The workarounds don’t apply to sole proprietorships or limited liability companies with only one member — if they did, some wage earners might form one, pay themselves as a contractor, and set themselves up to be eligible for the full SALT deduction. The cap doesn’t hit businesses that pay corporate income tax.
The bypasses involve states levying a new tax on a business, at a rate roughly equivalent to the state’s top individual rate. The move lets the business deduct its payment of the tax as a business expense on its federal return, and functionally gives the owners an offset — an amount they can subtract from their federal tax bill — for ‘paying’ their state taxes, thus preserving their SALT deduction.
Connecticut makes paying a workaround tax mandatory for businesses, at 6.99%, but in New Jersey, Louisiana, Maryland, Oklahoma, Rhode Island and Wisconsin, it’s optional.
Where it gets complicated, experts say, is when owners or investors in a business or fund are spread out across America.
Say you’re part of a commodities investment fund organized as a partnership in New Jersey. Three fund owners live in that workaround state, while two others reside in New York. The partnership uses the bypass and distributes its profits. The three New Jersey owners preserve their SALT deduction. The New York owners might think that they do, too.
Only they don’t.
Financial planners know that most states tax their residents on the income they earn in all states, not just on where they live. And that under federal law, states give a so-called ‘reciprocal’ credit that offsets taxes paid in other states, so that you’re taxed only on where you actually live.
But reciprocal credits are for people, not for businesses. Because the SALT cap workarounds have shifted things from the individual to the business, a state might not give you a reciprocal credit for the tax paid on your behalf by your business. As such, the workarounds, “while well-intentioned, can effectively double the tax burden,” Wagner says, causing the New York owners to owe New York state tax as well as New Jersey state tax.
With New York’s rates topping out at more than 8.8% — and nearly 13% for Manhattan residents — those New York owners who each get a $1 million distribution from the New Jersey fund lose nearly 10% or more of their profits when using the New Jersey workaround. “Essentially, you’re paying double tax on the same income,” says Elizabeth Pascal, a tax partner at law firm Hodgson Russ in Buffalo, New York.
‘Subsidizing’ other business owners
The result, according to a note by law firm Cole Schotz, can leave out-of-state business owners and partners (the New York investors) feeling that they are “unwittingly subsidizing” the personal state tax bills of owners who live in the state where the business is located (the New Jersey investors).
Christopher Doyle, also a partner at Hodgson Russ and the firm’s State and Local Tax Practice Leader, says he thinks that states will eventually find ways to avoid collecting the additional tax.
But for now, Pascal says, because all owners of a partnership typically have to agree to use a SALT cap workaround, financial advisors for businesses with far-flung partners “are the ones that have help their clients try to figure out” if using a workaround “is worth it.”
Leave a Reply