The SALT Deduction: When Facts Sound like Fiction

A highly improbable story is unfolding in real time across the country, and it’s all true. It’s another story about political dysfunction, but it’s not one that most have heard yet, at least not in its entirety. It’s a story centered on taxes, in which the last two Presidents, Congress, the IRS, and nearly half the states have all played important parts; and it’s a story of complexity, irony, and unintended consequences.

You could say that our story begins a long time ago, with the enactment of the Revenue Act of 1913 after the 16th Amendment was ratified (authorizing a federal income tax). That early predecessor to the modern Internal Revenue Code allowed a deduction for state, local, and certain other taxes paid during the year – an allowance that, with some variation over the years, was incorporated into the Internal Revenue Codes of 1939, 1954, and 1986 (the current version).

Over 100 years later, the Trump Administration, which had campaigned on a platform of reducing taxes, worked with a Republican-controlled Congress to enact The Tax Cuts and Jobs Act of 2017 (“TCJA”). Ironically, however, the TCJA wasn’t all about “tax cuts” or “jobs.” It contained a new provision that limited the deduction for state and local taxes (commonly referred to as the “SALT deduction”) to $10,000 for a married couple. Though paired with several tax cuts, this limitation was a substantial tax increase that primarily would be felt by higher-income residents of higher-tax states. Previously, the SALT deduction had been limited in other ways, including the alternative minimum tax (“AMT”), but this latest limitation was among the most impactful in the long history of the SALT deduction.

And so it was until 2019 and 2021, when the Republicans lost control of the House of Representatives and then the Senate and Presidency to the Democrats, who also happened to control most of the states with the highest tax burdens. Now, despite a platform of tax equity and higher taxes for the wealthy, most Democrats began pushing for a repeal or partial repeal of the SALT limitation. That’s right: In a strange irony (considering their respective platforms), Democrats began pushing for a tax break that, according to IRS data, would mainly benefit wealthier taxpayers, while Republicans pushed to keep their tax increase in place.

But the states were not about to wait for a federal solution to this improbable skirmish between Democrats and Republicans. Many decided to take matters into their own hands, particularly with respect to the large number of businesses that are structured as partnerships, limited liability companies, and S corporations and taxed as pass-through-entities (“PTEs”). Starting with Connecticut, state after state began to enact new laws that allowed PTEs to pay the business-related income taxes of their owners at the entity level, thereby turning these payments into largely unlimited business deductions. In effect, they came up with a partial workaround for the SALT limitation by transferring the point of taxation from the individual (where the deduction would be limited) to the entity (where the deduction generally would not be limited).

One might have expected the IRS to challenge this workaround, but it did not. It did the opposite by issuing a notice in late 2020 agreeing that PTEs may claim entity-level deductions for state income taxes paid under state laws that shift the burden from the owners to the business entity.

Over the next several months and throughout 2021, federal and state authorities pursued two separate tracks. On one track, Congressional Democrats and President Biden pursued the repeal or relaxation of the SALT limitation. On the other, more states (over 20 so far) enacted a SALT workaround for PTEs.

As the year ended, however, the first track was at least temporarily halted when Senator Manchin announced that he would not support the Build Back Better Bill, which contained partial SALT limitation relief. As for the second track, the plot thickens. While each of the above states enacted its own SALT workaround with its own nuances and limitations, the PTE world has benefited dramatically. Owners of PTEs doing business in one or more of those states now have a path to reclaiming much of the SALT deduction they lost through the TCJA. With some exceptions, most others have no such path.

Sound strange yet? Well, it gets stranger. First, the select people who can take advantage of the PTE workarounds can likely do so free of any AMT limitations because the PTE workarounds generally operate by reducing taxable income at the entity level and not directly at the individual level where the AMT otherwise would apply.

Second, these fortunate people are also likely to get a break on their self-employment taxes (Social Security and Medicare) – again because of how the workarounds operate. While the IRS has not yet weighed in on these additional benefits, it seems likely for now that they will be available.

So how does our story end? Well, it’s probably not over yet. Congress, the President, the states, and the IRS will all have roles in the last chapters. As of the end of 2021, however, it ends like this: Most Democrats wanted to restore at least a portion of the SALT deduction for high earners in high-tax states, but most Republicans did not. When nothing happened in Congress, the states and the IRS got involved, and a select group of PTE owners not only got a SALT benefit but also got some extra benefits – while most others got nothing.

And that’s not fiction. It just sounds like it.