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As Congress wrestles over changes to the $10,000 cap on the federal deduction for state and local taxes, known as SALT, many business owners already qualify for a workaround.
Enacted by the Tax Cuts and Jobs Act in 2017, the SALT cap has been a pain point for filers in high-tax states, such as New York and New Jersey. And some lawmakers have been fighting to include a change in the Democrats’ spending plan.
While the House package raises the SALT deduction limit to $80,000 through 2030, negotiations are ongoing in the Senate, with concerns over how to reduce the tax break for the wealthy.
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In the meantime, nearly 20 states are offering workarounds for the write-off limit for certain businesses, and others have pending legislation.
Although the IRS and U.S. Department of the Treasury have blocked some individual strategies to bypass the cap, some states have another method for pass-through businesses such as partnerships, S-corporations and some LLCs.
The IRS issued guidance on these state-level tactics in November 2020, offering the green light to certain businesses.
Nearly 20 states have enacted workarounds, with some effective in 2022 or later, according to the American Institute of CPAs, and there are pending laws in Massachusetts, Michigan, North Carolina, Ohio and Pennsylvania.
While the maneuver may offer tax savings for some business owners, it may not be the right move in all cases, financial experts say.
“The devil’s in the details,” said certified financial planner Sharif Muhammad, founder and CEO of Unlimited Capital Advisors in Somerset, New Jersey.
How the tax on pass-through businesses works
Most U.S. companies are pass-through businesses, with profits flowing to owners’ individual tax returns.
The new bypass typically involves a state levy on these businesses, allowing the company to cover part of the owner’s state income taxes.
The pass-through business typically pays the levy. But while some states allow a deduction at the entity level, others offer a credit for taxes paid.
The numbers have to be laid out, and everybody has a different situation.
Sharif Muhammad
CEO of Unlimited Financial Services
For example, in California, some businesses can pay an extra 9.3% levy on each owner’s share of the company’s net income.
Owners who participate may then claim a credit on their California tax return equal to the 9.3% tax.
“You’ve effectively prepaid your state taxes on your pass-through income,” said Perry Ghilarducci, a CPA and partner at Avaunt Ltd. CPAs & Consultants in Sacramento, California.
Not right for all businesses
The workarounds may seem like a welcome relief for business owners shelling out tens of thousands of dollars in property and state income taxes every year.
However, it’s critical to crunch the numbers before making any moves, Muhammad said.
A business owner needs to review their taxes at the entity and personal level, he said. For example, if they don’t itemize deductions, the benefits may not be as significant.
Moreover, a business owner in a lower tax bracket may overpay their state levies for the year, Ghilarducci said.
“The numbers have to be laid out, and everybody has a different situation,” Muhammad added.
