High-tax states trying to help residents avert the $10,000 federal cap on deductions for state and local taxes are resuming efforts that were largely sidelined during the pandemic.
A half-dozen states from New York to California are slated in 2021 to take up workarounds to the cap following IRS approval last month of tax mechanisms that seven states have in place for pass-through businesses like partnerships and S corporations.
Some Democrats in Congress have pledged to pursue raising the deduction cap, a move that would likely affect states’ actions. Even working with the new Biden administration, however, the effort will be an uphill fight.
Minnesota and Alabama will join in on anti-cap efforts from high-tax states next year with proposed workarounds of their own, and the potential such mechanisms have as much-needed revenue raisers could embolden more states to follow.
The workaround approach the IRS approved has limited appeal, since it applies only to owners of pass-through businesses. Still, as other state approaches were struck down by the IRS, pass-through workarounds remain attractive as the sole option blessed by the agency.
Each state’s workaround is unique, although they all essentially use an extra, mostly optional, business-level tax on owners of pass-through businesses, which the businesses can pay in exchange for a credit to redeem on their personal income taxes. Since the federal SALT cap only applies to individuals, it doesn’t impact the business-level tax that states created for workarounds.
New York, Minnesota, Alabama
New York lawmakers introduced pass-through workaround legislation earlier this month, which bill sponsors have promoted as relief for taxpayers under financial stress from the pandemic. The bill would align New York’s tax code with the IRS’s ruling “to provide a common-sense benefit—at no cost to New York State—for the 2020 tax year,” state Sen. James Skoufis (D) said in a press release.
In Minnesota, a proposal for a similar workaround is “a lock to be reintroduced” in the next legislative session, according to Mark Haveman, executive director of the Minnesota Center for Fiscal Excellence, a nonpartisan research organization.
“The state Chamber is pushing it and there appears to be considerable receptivity to it in both the House and Senate,” Haveman said.
Alabama will consider a proposal in 2021, as well. With the prospects of a special session, that could come as early as January, according to Bruce Ely, a partner at Bradley Arant Boult Cummings LLP in Birmingham, Ala.
“You will see a number of these bills introduced next spring, likely including our bill, although it will be somewhat retooled to take into account what these other states are doing,” Ely said, referring to efforts in Alabama.
If New York and California—where lobbying groups are pushing for pass-through entity taxes—enact the workarounds, even more of the country could follow.
Paying Less, Collecting More
Some states could choose to use the entity-level tax as a revenue raiser in their hunt for money after coronavirus economic blows. Connecticut, home of the first pass-through workaround, has done so.
As part of their 2019 budget, Connecticut lawmakers lowered the redeemable credit’s value to 87.5% from 93.01%—which raises the income tax liability of each partner or shareholder but still leaves pass-through owners paying much less federal tax than they had before.
So if a pass-through business in Connecticut pays $100,000 in state income taxes, and that liability flows through to its partners, they now receive a lower credit—$87,5000 instead of $93,001. But because they can fully deduct their SALT taxes, they likely end up paying much less than they would have without the workaround.
If other states enacted workarounds and cut back their credits, they too could collect more taxes while the taxpayer shells out less.
“States are looking for more and more revenue, so this could be an avenue for them to get it without it being too controversial of an item to raise revenue over,” said Todd Hyman, a partner and national leader in the multistate tax practice at Deloitte LLP in Philadelphia.
Such a tactic could be especially helpful to states already poised to adopt the workaround, as many high-tax states will be especially cash-strapped going into 2021.
Both New York and California sit right at or slightly below the average state’s 5% year-over-year drop in revenue from April to September, and New York Gov. Andrew Cuomo (D) is calling for ways to collect more taxes next year.
Minnesota is even lower on revenue. Its 6% year-over-year drop over the same time period ranks 15th-worst among all states, just four spots behind Connecticut, according to data compiled by the Urban Brookings Tax Policy Center.
Learning From Others
Not many pass-through business owners chose to take advantage of state workaround options last year. That will likely change going into 2021. Now that the IRS has approved the strategy, more states will adopt it, and businesses have time to acclimate to the change, Hyman said.
“This is a good time to learn from other states’ mistakes and successes,” Ely said.
A case in point is Oklahoma’s law, which gave businesses just 60 days to decide if they wanted to opt in.
“It didn’t really give taxpayers enough time to understand the regime and decide if electing in would be worthwhile.” Hyman said. “Other states should want to look at when they make their election date.”
The degree of choice pass-through owners have is another consideration for states and taxpayers.
In Connecticut, the entity tax is mandatory for pass-through businesses, and owners can’t get out of it even if they ask. Louisiana’s isn’t technically mandatory, but businesses are required to submit extensive information to the state before opting in. Louisiana regulations also require the revenue secretary’s approval not to pay the entity tax.
Jaye Calhoun, partner in Kean Miller LLP’s New Orleans office, said the information that must be filed could make pass-through businesses much easier to audit.
“That was of concern to clients,” she said. “Do we really want to just hand them all this information?”
States tend to like these entity taxes for that very reason: rather than having to pursue all the shareholders, members or partners, they can just pursue the entity, Ely added.
“It decreases the compliance workload on the state level,” he said.
Ideally, Calhoun said, the next state that adopts an entity tax would make electing in and out easier for businesses.
“That was a concern,” she said. “Do we really want to sort of risk the possibility that the department will not allow a termination of elections, even if the federal tax law changes?”
If Democrats who oppose the deduction cap were to succeed in changing it, fewer states would bother with workarounds, as the already select group of taxpayers that would realize the benefit would shrink even more, said Jess Morgan, senior manager of state and local tax EY’s national tax practice in Washington.
Among states that already have the tax, Morgan said more states are likely to follow Connecticut and lower their credits.
Either way, the cap is set to expire in 2025, which should give states pause in creating these workarounds,, she said, as they would have left in place the framework for a new tax on pass-through entities doing business in these states. That raises a key issue around jurisdiction.
“The workarounds are brought into place because the state has jurisdiction to tax individuals that are earning income in the state,” Morgan said. “What we’ve done is transformed that, and we are asserting a tax on the privilege of doing business or earning income in the state, so now jurisdiction is over the legal entity.”
Once the pass-through entity has filed its return, presumably the facts of that business, such as how and where it earns income, would have to change if that business wants to stop filing in the state in the future, she said.
“Opting in is not a decision to make lightly,” she said.