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SALT Workarounds Carry Consequences for Tax Affected Earnings

Sept. 23, 2022, 8:45 AM

Once again, necessity is the mother of invention. It is no secret that the $10,000 SALT itemized deduction limit imposed by the 2017 Tax Cuts and Jobs Act spurred lots of unhappy chatter, particularly for people in states with the highest income tax rates. Topping the charts are California at 13% and Hawaii at 11%. You can hear residents complaining, “Like it wasn’t expensive enough to live there already—now I can’t deduct my state taxes!”

In response to such complaints, many states have implemented SALT “workarounds” by enacting a pass-through entity income tax option, which allows PTEs to pay (and deduct) state income taxes at the entity level, effectively bypassing (working around) the federal individual SALT deduction’s $10,000 limit.

According to the American Institute of Certified Public Accountants, 29 states and one city have passed a PTET, two states have a proposed PTET legislation in committee, and the remaining 10 states with an owner-level personal income tax on PTE income haven’t yet proposed or enacted a PTET.

Yes, I realize SALT workarounds have received their share of news coverage. Yet related unintended consequences, such as the workarounds’ impact in valuation of business and economic interests, are often overlooked and create traps for the unwary, such as complications in “tax affecting” earnings as described herein.

PTEs classified as S corporations, partnerships, and multimember LLCs pay no federal income tax at the entity level. Instead, the PTE income is reported, and personal income tax is due on PTE earnings at the owner level. However, business appraisals under the Fair Market Value Standard of Value are viewed from the perspective of hypothetical buyers and sellers and are benchmarked against an “after tax” cost of equity. Accordingly, consistency requires that earnings be “tax affected” to reflect the economic reality of taxes due on such earnings by applying an appropriate ‘blended” tax rate to include the federal, state, and local income tax rate to estimate owner-level income tax payable on PTE income allocated to the hypothetical buyer or seller of the PTE interest.

Although a settled issue among business appraisal professionals for years, tax affecting of earnings in appraisals of PTEs remains a highly contentious issue in IRS business value disputes. A major contributing factor is that over the last two decades, the US Tax Court has shown no inclination to adjust poorly developed calculations of tax affected earnings. In such cases, the Tax Court tends to throw out tax affecting altogether, effectively blessing business valuations by the IRS based on pre-tax earnings rather than on after-tax earnings, often resulting in material overvaluation of business interests and far greater resulting liabilities for income taxes, interest, and penalties. Consequently, the IRS is emboldened to continue its crusade against tax affecting, often going to the mat on this issue.

So where is the valuation complication (trap)? A PTE can now opt to file an income tax return that includes a new workaround-related SALT deduction, where previously no such deduction was allowed or taken. Consequently, if the SALT workaround option is elected, the effective tax rate used for tax affecting now must exclude the impact of personal state and local income tax rates to avoid “double dipping.” Only one benefit of a state income tax deduction is allowed, and that can be accomplished through either an actual deduction for SALT or through tax affecting—but not both.

The danger here is that an appraiser could easily overlook the deduction taken and fail to adjust the effective tax rate while tax affecting earnings. Given the IRS’ disdain for tax affecting—and the Tax Court’s apparent unwillingness to recalculate effective tax rates—accuracy in tax affecting of earnings is paramount. Improper application of tax rates increases the likelihood of assessment of unwarranted income taxes, interest and penalties due to overvaluation of business interests, not to mention legal and other professional fees required to properly defend the taxpayer against the IRS. This scenario could needlessly leave the affected taxpayer(s) in financial ruin.

You might be wondering what could further complicate the situation—or is it just me? Imagine a client who owns an interest in an S corporation that earns income in 35 states, many of which have a SALT workaround option, others that do not, and a few with no state income tax. As you can see, complexity compounds quickly.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Bruce C. Wood is principal at Brady Ware Arpeggio, LLC in Alpharetta, Ga. As a business appraiser specializing in IRS-related valuation matters, he advises attorneys in IRS valuation disputes in US Tax Court, IRS appeals and audits, and estate, gift, and trust tax planning or compliance.

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