The Tax Cuts and Jobs Act of 2017 limited the State and Local Tax (“SALT”) deduction to $10,000, which significantly impacts taxpayers (particularly small business owners) living in states with a state income tax. In fact, many taxpayers that typically itemized deductions and received significant refunds now find themselves instead selecting the standard deduction and receiving a significantly lower refund, or even owing taxes. While there have been some proposals to roll back the SALT deduction limitation at the federal level, nothing has been enacted.
In lieu of any action at the Federal level, many states have enacted legislation to alleviate the burden placed on state residents by the SALT deduction limits. As the SALT limitations are placed on individual tax filers, not entities, these workarounds generally provide that state taxes can be paid by partnerships and S corporations at the entity level rather than by the individual owners, as was previously the case. These workarounds are not available to single member limited liability companies or any entity taxed as a disregarded entity because disregarded entities are ignored for income tax purposes. As a result of these workarounds, the partnership or S corporation can deduct the entirety of the entity’s state and local taxes on the entity’s federal return, with these savings ultimately passed on to the owners. The IRS has essentially blessed this approach in IRS Notice 2020-75, which provides some comfort to taxpayers if they elect to take advantage of these new laws.
The approach taken by each state that has passed one of these workarounds varies. For purposes of this post, I will be describing the approach Colorado has taken because Colorado recently became the first state to allow entities to retroactively take advantage of its workaround. Colorado law allows partnerships and S corporations to apply the state’s corporate tax rate at the entity level. The entity can then deduct the full amount of state and local taxes incurred by the entity for federal income tax purposes. The owners of the entity can then claim a refundable Colorado tax credit equal to each owner’s pro rata share of the taxes paid by the entity. Colorado also provides that entities can amend prior returns to apply this new law retroactively to 2018, though the process to do so is quite onerous, particularly for partnerships and S corporations with a significant number of owners. Moreover, Colorado also allows a Colorado resident that is an owner of an out-of-state partnership or S corporation located in a state with a similar SALT workaround to receive the benefits of such workaround.
The structure of these workaround laws allows state residents that own partnerships and S corporations to take advantage of a full SALT deduction, at least with regard to the entity’s taxes, avoid double taxation at the state level, while also being revenue neutral at the state level. As a result, owners of partnerships and S corporation that are impacted by the SALT limitation should inquire as to whether one of these workarounds is available and whether it would be advantageous to take advantage of such workaround. Additionally, as these workarounds are not available to entities treated as disregarded entities for tax purposes (even if these entities have been filing protective partnership tax returns), owners of disregarded entities should consider converting such entities to partnerships or S corporations to take advantage of these laws.
No action should be taken before conferring with your tax advisor. Some actions, such as conversion to an S corporation, can have significant long-term impacts on your business. Thus, you need to weigh whether these long-term ramifications are worth the potential tax savings. Regardless, these laws can provide a valuable tool to help alleviate the additional tax burden brought upon by the SALT deduction limitation.