Quash SALT Deduction Cap Loopholes to Advance Taxpayer Equity

The dismissal of New York’s, New Jersey’s, and Connecticut’s challenges to the state and local tax deduction cap strikes a blow against the charitable deduction loophole, an effort that aims to circumvent the cap introduced by the Tax Cuts and Jobs Act.

However, other state efforts such as the pass-through entity loophole allow for the full deduction for entities. Because the SALT cap doesn’t apply to entities, taxpayers who have resources to structure their finances and holdings to flow through an entity can continue to enjoy the benefits of full pre-cap SALT deductions.

The disparate treatment leaves average taxpayers in high-tax states to bear the brunt of the cap and permits an escape hatch for those with means to engage in complex tax planning. This demands immediate legislative reassessment even ahead of the SALT cap’s planned 2025 expiration.

Pass-Through Entity

The $10,000 SALT deduction cap disproportionately affects residents in high-tax states by limiting their ability to deduct state and local taxes from their federal tax obligations. In states where SALT obligations typically exceed $10,000, some portion is nondeductible from federal income.

States have responded with efforts to circumvent the cap—allowing for tax credit awards for contributions to specific charities. This is what the latest court dismissal bans.

But the so-called pass-through entity loophole is still in effect. States including New York, New Jersey, and Connecticut passed laws that permit pass-through entities to elect to pay state income taxes at the entity level instead of as personal income.

The SALT cap has been a thorny issue politically across the board—the cap disproportionately affects higher-income people in Democratic states. However, arguing for tax breaks that benefit higher-income individuals isn’t typically a talking point for Democrats.

Similarly, Republican politicians aren’t generally thought to be in favor of higher taxes on the rich. Thus, party lines mean less than state lines when it comes to support for the SALT cap.

The additional context of the pass-through entity loophole, however, should realign political interests. While the uncapped SALT deduction favored high-net-worth individuals in predominantly Democratic high-tax states, a cap and corresponding exploitable loophole shifts the advantage even more explicitly toward those with resources to engage in sophisticated tax planning.

A policy in which tax relief depends on the ability to employ complex financial strategies underscores the ongoing and critical flaw in piecemeal SALT cap legislation.

The current dynamic should be found untenable across party lines. Doing so would offer both sides of the aisle common ground for reconsideration—and an incentive either to fix the SALT cap or eliminate it in favor of more targeted progressive tax reforms.

Broader Context

Prior to 2017, the SALT deduction was a cornerstone of the tax code that allowed taxpayers to deduct taxes paid to state and local governments from their income for federal tax calculation purposes.

Theoretically, allowing for a deduction ensures the federal government isn’t taxing income already laid claim to by state and local tax authorities—that is, it prevents double taxation.

The deduction didn’t benefit all state residents equally, however. Any deduction that is keyed to an amount paid to a state or local entity will be open to political attack as, at base, a funnel channeling money out of federal coffers and into state tax revenue.

The actual-dollar value of the deduction is higher for residents of higher-tax states, and it results in more federal tax revenue loss to those states than to lower-tax states. States can raise taxes without forcing residents to feel the full effects, allowing some of the cost to be offset by a corresponding reduction in federal tax liability.

Coupled with higher-tax states tending to be Democratic-leaning ones, including New York, New Jersey, and Connecticut, the situation was ripe for politicking—many saw the introduction of the SALT cap in 2017 as predominantly an attack on Democratic politicians and their voters.

Status Quo

The federal court’s decision to dismiss state challenges to the cap marks a turning point in the broader context of tax equity and fairness. The closure of the charitable deduction loophole closes one path to tax avoidance but leaves another one wide open.

The solution to the SALT cap issue lies not in continued patchwork fixes and ad-hoc litigation outcomes, but in a fundamental reevaluation of the SALT cap itself. The cap either needs to be eliminated entirely or applied uniformly to all taxpayers.

If the identity of the taxpayer—whether an individual or pass-through entity—determines the availability of a full deduction, whatever progressive aims are intended to be furthered by implementing the cap will be significantly undermined.

Andrew Leahey is a tax and technology attorney, principal at Hunter Creek Consulting, and adjunct professor at Drexel Kline School of Law. Follow him on Mastodon at @andrew@esq.social

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