Timothy Gray Ingram
Historically, U.S. taxpayers have been able to deduct their state and local taxes from their federal taxable income. This changed with the passage of the Tax Cuts and Jobs Act of 2017, which introduced a $10,000 cap on the state and local tax (SALT) deduction. States have reacted by turning to various methods to mitigate the negative tax consequences of the cap for their residents, including workarounds that use the charitable contribution deduction or a payroll tax as a means to allow full deductibility of state and local taxes.
With the IRS striking down the charitable contribution workaround, and the payroll tax workaround being difficult to implement, the latest development has been a pass-through entity workaround. Generally, the pass-through entity workaround allows pass-through entities to pay their income tax at the entity level. The owners of the entity then report their pro rata share of the entity’s income on their individual state tax return. Finally, the state provides each owner with a tax credit equal to that amount of taxes. The tax benefit for the owners is that the tax paid at the entity level is deductible a business expense, meaning it is not subject to the SALT cap. Thus, the owners are able to deduct the full amount of state and local taxes that they pay.
The Internal Revenue Service issued Notice 2020-75 on Nov. 9, 2020, which suggested that forthcoming regulations would permit the pass-through entity workaround. But it has now been over two years since this Notice was issued under the Trump administration, and there have been no developments on this front under the Biden administration.
This Note argues that the Internal Revenue Service should instead issue regulations denying the validity of state legislation allowing for the pass-through entity workaround. In doing so, this Note examines the legislative history of the SALT deduction, compares the pass-through entity workaround to the charitable contribution and payroll tax workarounds, and analyzes public policy arguments for and against the workaround. Ultimately, it concludes that the workaround raises public policy and substance-over-form concerns and that the Treasury Department and IRS should issue regulations disallowing it.