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Danger Ahead? IRS Greenlights Passthrough Workaround to SALT Cap

Posted on Nov. 12, 2020

The IRS’s notice of coming guidance giving the all-clear to SALT cap workarounds involving entity-level taxes on passthroughs has some experts flying high and others warning of danger, including its potential to raise reliance issues.

In Notice 2020-75, issued November 9, Treasury and the IRS greenlight a type of workaround to the $10,000 cap on the state and local tax deduction first adopted by Connecticut, a state hit hard by the limitation. The strategy involves a state imposing entity-level tax on passthroughs and creating an offsetting individual income tax credit for the entity’s members.

“This week’s IRS announcement is welcome news and affirms Connecticut’s response to help state taxpayers who were impacted by federal tax changes,” said John Biello, the state’s acting revenue commissioner, in an email to Tax Notes.

The IRS’s notice isn’t the only recent development related to the SALT cap, which has always been one of the more controversial provisions of the Tax Cuts and Jobs Act. The Second Circuit has scheduled oral arguments for December 3 in New York v. Mnuchin, one of the cases brought by states challenging the cap as unconstitutionally coercive.

That is the suit filed by New York, New Jersey, Connecticut, and Maryland in 2018 against Treasury and the IRS and their heads. “The Trump Administration’s SALT policy is retribution politics, plain and simple,” New York Gov. Andrew Cuomo (D) said last year when the states filed to appeal a federal judge’s dismissal of the case. The scheduling means the Trump administration will participate in the oral arguments.

The timing of the IRS’s notice — released one week after the presidential election, describing a position that it said taxpayers can rely on immediately and apply retroactively — elicited comment from several passthrough experts.

“My first question was, why now?” said Bruce Ely of Bradley Arant Boult Cummings LLP. “We’ve heard that Treasury officials have been directed to issue any remaining guidance on TCJA by the end of the year, so this may simply be a part of that last batch.”

“I was pleasantly surprised by the IRS notice so soon after the election,” said Steve Wlodychak of EY. Like Ely, he said he expected a flurry of state legislative activity and widespread consideration of model legislation promoted by the Parity for Main Street Employers coalition.

The coalition’s model approach is simply an attempt to level the playing field between publicly held C corporations and privately held passthrough businesses under the TCJA, said Thomas J. Nichols of Meissner Tierney Fisher & Nichols SC.

“The single tax passthrough system is much more efficient and much less distortive, which is why the vast majority of closely held businesses have elected to be taxed that way,” said Nichols, who helped develop Wisconsin’s passthrough workaround law. “Treasury and the Internal Revenue Service were no doubt aware of this when they decided to clear up any uncertainty in this area.”

EY’s David H. Kirk, formerly an attorney in the IRS Office of Associate Chief Counsel (Passthroughs and Special Industries), had a different view of the timing of the IRS notice and on its taking immediate effect.

“It has pinned the next administration into a unique position,” Kirk said. “If they disagree, how do they undo it?” A new administration could yank the notice and the forthcoming proposed guidance, he said, but that would create reliance problems.

Kirk and Wlodychak both warned that the approach described in the IRS's notice could set up a conflict among the states over out-of-state credits for nonresident partners. “Owners of passthrough entities that operate solely in a single state should be incredibly pleased by the announcement,” Wlodychak said. “Ambiguities continue to exist for resident owners of passthrough entities engaged in a multistate business.”

The issue is whether states will treat entity-level taxes as creditable for purposes of their resident income taxes. Blue states could be pitted against red states — or there could be a race to the bottom until every passthrough is a corporation for state tax purposes.

“Are taxpayers going to have to fight the Wynne case all over again, with a Court whose membership may be more skeptical of dormant commerce clause jurisprudence?” Wlodychak asked. “Unless we get resident state tax relief to these questions, passthrough owners are just trading a 36 percent federal tax benefit for a $1-for-$1 state tax increase in their home states.”

It's already likely that a partner could pay its distributive share of Connecticut’s entity-level tax but not get a credit for it in Virginia and wind up worse off economically, Kirk said, citing Virginia Rev. Rul. 81-288.

The Notice

Developed by the Connecticut Department of Revenue Services on behalf of then-Gov. Dan Malloy, who introduced the workaround less than two months after the Tax Cuts and Jobs Act was enacted, the strategy takes advantage of the fact that the $10,000 cap applies to individuals only. The idea is that passthroughs — as businesses not subject to the limitation — can fully deduct on their federal return the entity-level SALT payment while the distributive share of the tax payment passed on to partners is both lowered and offset by a newly created state individual income tax credit.

Notice 2020-75 never used the word “workaround,” but it said Treasury and the IRS are aware of strategies popular in the states involving elective or mandatory entity-level taxes on passthroughs and “a corresponding or offsetting, owner-level tax benefit, such as a full or partial credit, deduction, or exclusion.” The notice said Treasury and the IRS also recognize there is uncertainty over whether entity-level tax payments made as part of these strategies “must be taken into account in applying the SALT deduction limitation at the owner level.”

The answer is no. Entity-level payments are not “taken into account in applying the [SALT] deduction limitation to any individual who is a partner in the partnership or a shareholder of the S corporation,” the notice said. The notice said Congress, in enacting the SALT cap, provided for precisely this treatment, “as under present law,” and it quoted a footnote from the House report on the TCJA.

The purpose of the coming IRS proposed regulations is to provide certainty that direct taxes imposed on and paid by a partnership or S corporation at the entity level are fully deductible, and that these entity-level payments will continue to reduce a partner’s distributive share of income, the notice said.  

And taxpayers can rely on that position effective immediately, according to the notice. Taxpayers also will be able to apply the proposed regs retroactively to tax years ending after December 31, 2017, and before the date they are published in the Federal Register.


Nichols is the author of a widely circulated memo providing a legal analysis of Wisconsin’s entity-level tax SALT cap workaround and the legal foundation supporting such strategies. Kirk said Nichols’s writing might have won the day with Treasury and the IRS

“We’ve been arguing for three years that the law was on our side, and this notice confirms that,” said Brian Reardon of the S Corporation Association. The IRS notice “removes the last bit of uncertainty” about the passthrough workarounds, he said. “States have no excuse now not to act and help restore these deductions for their S corporations and partnerships. We’re working in a dozen states to get this enacted early next year.”

Connecticut is the only state to date to make its entity-level tax mandatory. The tax is elective in the versions of the workaround adopted by Wisconsin, Oklahoma, Louisiana, Rhode Island, and New Jersey. But aside from Connecticut, there has been little participation in the passthrough SALT cap workaround strategies, which practitioners have attributed to uncertainty about whether Treasury and the IRS would treat the workaround as legitimate.

There was a reason for the uncertainty. When Treasury and the IRS in 2018 attacked SALT cap workarounds involving charitable contributions in exchange for state tax credits, they also put taxpayers on notice that they’d be monitoring other strategies to ensure that federal law controls the characterization of deductions for federal income tax filings.

Some state tax experts took that as a sign that Treasury and the IRS might invoke quid pro quo principles to deny the SALT cap passthrough workaround or challenge its economic substance, or apply substance-over-form principles to the strategy. Would the IRS argue, for example, that an elective tax on passthroughs that is creditable for personal income tax purposes isn’t actually a tax on the entity at all?

“I continue to believe these taxes are vulnerable to a substance-over-form challenge, but the IRS has clearly waved the white flag on the elective passthrough entity scheme for some reason,” said Gregory A. Nowak of Miller, Canfield, Paddock and Stone PLC. He said it would have been logical had Treasury and the IRS applied that doctrine to recharacterize an elective entity-level tax as an individual tax subject to the cap. “It will be interesting to see how the next administration approaches it,” Nowak said.

Another possibility floated was that the IRS could identify the passthrough workaround strategy as a listed transaction.

But experts questioned how Treasury and the IRS would thread the needle in defining which entity-level state and local taxes are no longer legitimate business expenses deductible by passthroughs without sweeping up stand-alone entity-level taxes that are not part of a SALT cap workaround strategy.

Kirk said the IRS’s position is surprising. The approach is facially inconsistent with the intent of Congress in creating the concept of adjusted gross income in 1944, he said, adding that that's explained in Rev. Rul. 81-288 — more recent guidance than that cited in the IRS notice. The revenue ruling says that when Congress created AGI, it was trying to come up with a way to provide equity to business and individuals.

Kirk said that for federal tax purposes, a passthrough owner with $1 million on its Schedule K-1 is in a better overall position than an individual W-2 taxpayer earning $1 million. To take advantage of the passthrough SALT cap workaround that now has the approval of the federal government, there should be a resulting shift from individuals being employees to being owners — that is, the IRS notice arguably is changing the economics of what is happening, he said. 

But while there might be some academic unfairness with the approach, Kirk said the IRS notice is undoubtedly very favorable to taxpayers.

Practitioners said any of the above issues could be raised in comments that will be submitted to the IRS on its forthcoming proposed regulations. But they questioned whether the IRS will hold a hearing, given that the guidance is so favorable to taxpayers.

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