At a Glance
Main TakeawayState and local income taxes, commonly called “SALT,” have been the subject of much discussion in recent years. The $10,000 cap for the federal deduction for these taxes has been a point of contention, particularly among Congressional Democrats who are currently negotiating changes to the cap.Next StepDespite the ongoing debate, some states allow pass-through business owners to bypass the current cap. Understanding the SALT cap workarounds and the tax implications for your business can help you lower your tax liability.How Taxes Work for Pass-Through Businesses
A pass-through business is a structure where income generated is not taxed at the entity level. Instead, it passes through to the owners or investors, who report it on their personal tax returns. Examples of pass-through businesses include S-Corporations, partnerships, and limited liability companies (LLCs) taxed as partnerships. The tax treatment of pass-through businesses is advantageous for many business owners because it allows them to avoid the double taxation that occurs with traditional “C” corporations.State-Level Responses to SALT Caps
In response to the $10,000 SALT cap, many states have implemented pass-through entity (PTE) workarounds that allow business owners to reduce their federal tax liabilities. The business remits tax to the states on behalf of their eligible owners, and that tax payment is considered a deduction on the PTE’s federal tax return (and more importantly, the member’s federal schedule K-1). The states allow a credit for the tax paid on the member’s behalf on the member’s individual tax returns. This structure bypasses the owner’s itemized deduction limitation by allowing the federal deduction at the entity level. Because these PTE workarounds are so lucrative, there are often strict rules to participate and not every PTE owner is eligible to participate in PTE programs. For instance, C corporation owners of PTEs cannot participate. There are many states that offer a PTE program. Following are six states that offer clear examples of SALT workarounds for small private business owners:California
Assembly Bill 150 (AB 150) allows qualifying pass-through entities to pay an elective tax at the entity level on behalf of their eligible owners. The elective tax is then fully deductible on the owner’s federal tax returns and the payment is considered a nonrefundable credit on the owner’s California tax return. Businesses must opt-in by making an installment payment in June. The required installment is based on prior participation in the program, and the first payment must be timely, or the business will be ineligible to participate. The California PTE tax rate is 9.3%.Connecticut
Connecticut was the first to implement a PTE-level tax in 2018. Participation in the Connecticut PTE program is mandatory and the PTE must remit tax on its CT source income, with owners being eligible for a refundable credit of 87.5% of the taxes paid at the entity level. The Connecticut PTE tax rate is 6.99%.Massachusetts
Starting from tax years commencing on or after January 1, 2021, qualifying PTEs can remit tax on their “qualified income taxable in Massachusetts” at a 5% rate. The election is made annually on a timely filed tax return, including extensions. The election is irrevocable and qualified members cannot opt out. Individual owners of these PTEs who elect to do so can claim a tax credit equivalent to 90% of their distributive share of the PTE Excise tax paid. This tax will only remain effective while the federal SALT cap is in place.New Jersey
Starting on January 1, 2020, New Jersey implemented a provision permitting a PTE to be taxed at the entity level. Elections to participate are due by the original due date of the return (the 15th day of the third month) and estimated tax payments are required. The tax is assessed on the business’s New Jersey taxable income, calculated as 100% of each resident owner’s K-1 income and the New Jersey source income of each nonresident owner. Each member’s portion of the PTE tax is reported as a refundable credit. A refundable tax credit allows a taxpayer to lower his or her tax liability to zero and still receive a refund. A non-refundable credit takes the tax lability to zero but does not create a refund. The tax rate ranges from 5.675% to 10.9% depending on the income level.New York
The PTE tax became effective in New York for tax years commencing on or after January 1, 2021. New York’s PTE tax mirrors that of New Jersey in that elections to participate are due by the 15th day of the third month after the start of the tax year and estimated tax payments are required. The tax is calculated as 100% of each resident owner’s K-1 income and the New York source income of each nonresident owner and assessed on the business’s New York taxable income. The tax rate ranges from 6.85% to 10.9% depending on the income level. Each member’s portion of the PTE tax is reported as a refundable credit.Oregon
Oregon’s PTE tax is effective for tax years beginning on or after January 1, 2022. PTEs must register online with Oregon in order to participate and make required estimated tax payments. The election is made annually on a timely filed tax return, including extensions, and is revocable. The tax rate ranges from 9% to 9.9%, depending on the income level.Variables to Consider
Although PTE tax elections can be beneficial, they may not be suitable for every business. There are several critical factors to consider before making an election, including:Who Can Participate?
Some states require all eligible members to participate once an election has been made. Additionally, in some states PTE participation is not optional.Refundable or Nonrefundable?
In states that allow PTE tax election, owners are given credit on their state income tax return, reflecting the tax paid by the entity. In some states, PTE credits are refundable, meaning the state will issue a refund to the extent the credit pushes a members’ tax liability below zero. In some states, the credit is nonrefundable, and will carry over any unused credit to future tax years. If the state’s credit is nonrefundable, it is important to consider when the credits expire.Allocating Taxes Among Entity Owners
The entity must determine how to record and allocate the PTE tax between various owners without creating distinct shareholder classes, which could potentially void an S-election, or breaching partnership agreements.Tax Rate
The PTE credit often will not cover a participant’s entire state tax liability, especially in their state of residency. For example, California’s 9.3% PTE tax rate is lower than its maximum individual income tax rate of 13.3%, so there is a 4% spread for participants in this bracket.