Finally, a Solution to the Limits on State and Local Tax Deductions

Help is on the way for taxpayers taking a hit from limits on state and local tax deductions.

Beginning in 2018, the Tax Cuts and Jobs Act limited individual taxpayers to a maximum deduction of $10,000 for state and local taxes, or SALT. This meant that taxpayers whose combined state income tax and property tax exceeded $10,000 would lose out on the ability to claim a federal deduction.

Of course, this was a huge hit not only to high-income taxpayers but also for many middle-income residents of high-tax states, such as California, New York, and New Jersey. In an attempt to avoid the bigger tax bill, some states suggested allowing "donations" to the state in lieu of taxes. The IRS was all over that, nixing this methodology for avoiding the limitation.

Many thought that the Biden administration would repeal the SALT cap, but to date, such a change has not been included in budget proposals.

However, there have been other important developments.

As of November 2020, the IRS stated that the SALT limitation applied to individuals and not to businesses. Notice 2020-75 said that "state and local income taxes imposed on and paid by a partnership or an S-Corporation on its income are allowed as a deduction by the partnership or S-Corporation in computing its non-separately-stated taxable income or loss for the taxable year of payment."

This means that a pass-through entity such as a partnership, LLC, or S-Corporation can pay tax at the entity level while granting the individual owners a corresponding state tax credit. From a federal standpoint, the entity's pass-through taxable income would be reduced, effectively allowing the individual owners a workaround for the SALT limitation.

Robert Green wrote in a recent Forbes article that "Connecticut, Louisiana, Maryland, New Jersey, Oklahoma, Rhode Island, and Wisconsin have all adopted entity-level taxes which offer credits against the owners' personal tax liability. In Connecticut, the entity-level tax is mandatory. In the other six states, it is elective; business owners can choose to pay it and claim the credit, or may decline if it is not in their best interest to go that route."

The latest development is that on July 15, California Gov. Gavin Newsom signed AB 150, allowing pass-through entities to pay an elective tax of 9.3% on behalf of its individual owners, thus providing the owners with an equivalent state credit. The pass-through workaround will begin for tax-year 2021.

Many taxpayers with income from pass-through entities now have an opportunity to bypass a good portion of the SALT limitations. And, as an added bonus, these increased write-offs reduce adjusted gross income--a more valuable benefit than an itemized deduction. (A lower adjusted gross income can mean lower taxes on Social Security and more benefits from medical deductions, for example. And it might be possible to obtain a greater benefit from the standard deduction if state taxes become an "above the line" deduction.)

For taxpayers not in the above states, it's worth keeping an eye out for legislative changes that could ease this tax burden.

Sheryl Rowling, CPA, is head of rebalancing solutions for Morningstar and founder of Rowling & Associates, an investment advisory firm. She is a part-time columnist and consultant on advisor-focused products for Morningstar, and she continues to actively work in the advisory business. Morningstar acquired her Total Rebalance Expert software platform in 2015. The opinions expressed in her work are her own and do not necessarily reflect the views of Morningstar or of Rowling & Associates LLC.