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California Adopts Elective State Tax to Result in Federal Tax Savings

Insights

By Marjorie F. Smith, CFP®


Potential “Workaround” to SALT Cap Worth Investigating

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Business Owners of “Pass-Through” Entities May Benefit 

Our clients work hard to accumulate wealth and we want to help them be tax-efficient wherever possible. The $10,000 cap on what one can deduct in state and local taxes (SALT) is frustrating for California residents who pay some of the nation’s highest state income taxes. To reduce their federal tax liability, California taxpayers who own “pass-through” business entities may want to investigate a recently legalized “workaround” to the SALT cap.

First, a bit of background: The Tax Cuts and Jobs Act of 2017 included a $10,000 cap on the amount of state and local taxes taxpayers could deduct from their federal tax liability. The taxes, referred to as “SALT” taxes, are particularly high in states such as California, New York, and Illinois. The cap was the Trump administration’s attempt to keep these high-tax states from generating their own tax revenue at the federal government’s expense. Since then, the $10,000 cap has impacted affluent taxpayers who pay high state income taxes but can deduct only $10,000 on their federal tax return. 

Last year, however, the IRS published regulations [n-20-75.pdf (irs.gov)] to indicate its acceptance of a “workaround” for owners of “pass-through” businesses such as S-Corps and partnerships. Unlike C-corporations who deduct both state and federal tax at the corporate level before paying wages, “pass-through” businesses do not generally pay, and thus deduct, significant tax at the corporate level before distributing income. The new regulations sought to address what some saw as inequity. California is one of the many states who have adopted the new regulations. 

Here is how pass-through businesses can potentially circumvent the $10,000 SALT cap: Pass-through businesses do not pay federal taxes themselves. They may or may not pay corporate tax at the state level before earnings pass through to their owners, after they have deducted any corporate state tax and corporate expenses. The owners report those earnings as K1 distributions on their personal tax returns. At that point, taxpayers are subject to the $10,000 cap on state and local taxes. 

Many states now allow pass-through business owners to pay state tax at the corporate level where there is no cap on what a business can deduct. They are able to use tax credits on their personal tax return to offset the state tax paid at the corporate level. The result is a much lower state tax liability on the individual’s tax return, one that may fall under $10,000 and be fully deductible. State tax revenue will not change, but the federal government loses revenue since more taxpayers are not paying federal tax on what they’ve already paid in state taxes.  

In July of 2021 California’s governor Newsom adopted this solution by allowing business owners to pay an elective tax that would be applied as a credit on their personal tax return[1]:

Partners, members, and shareholders who consented to the pass-through entity making the election are allowed a credit equal to 9.3% of tax paid on their pro-rata or distributive share of the entity's income. If the credit exceeds the tax due, any unused credit may be carried forward for 5 years or until exhausted.

Keep in mind that property taxes and state taxes on all investments are included in the $10,000 SALT cap. Law firms, accounting firms, consulting firms, real estate investment companies, and other high-income businesses could benefit greatly from adopting this strategy. Other businesses may choose to restructure to take advantage of this legal workaround.

Not all are enthusiastic. Using this strategy could create internal accounting issues or unfairness for firms or businesses whose partners live in different states since not all states allow for the workaround. It may also be unfair that some high-tax states have not adopted the regulations. Those states’ residents could end up bearing more of the federal tax burden than others. Finally, some taxpayers may simply demand more clarity from the IRS before they restructure a business or complicate a tax return. 

California business owners who are personally liable for more than $10,000 annually in state and local taxes, should consult their CPA regarding this potential workaround to the $10,000 cap on deductions. Now is the time to investigate, as there are timing issues related to anticipating and paying the elective 9.3% tax. In an excessively high tax state such as California, the tax savings could be significant.  

[1] To read more, view California Approves SALT Cap Workaround - The CPA Journal and Pass-Through Entity Elective Tax | FTB.ca.gov.[1] 


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