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News Analysis: Could the IRS Identify SALT Workarounds as Listed Transactions?

Posted on Oct. 29, 2018

The American Institute of CPAs has published an issue paper discussing the potential benefits and risks raised by state workarounds to the $10,000 cap on the state and local tax deduction, though at first glance, the title of the paper — State Pass-Through Entity-Level Tax Implementation Issues — doesn't give that away.

While Treasury and the IRS have racked up nearly 8,000 comments on proposed regulations (REG-112176-18) addressing charitable contributions and state tax credits, the AICPA's October 4 paper moves one step beyond to focus primarily on SALT cap workarounds modeled after Connecticut's entity-level tax on passthroughs and offsetting personal income tax credit for entity members.

The 15-page paper provides a jumping-off point for debate about several aspects of the entity-level state tax approach, including whether the combination of provisions would even function as a SALT cap workaround — more on that later in this article. Another proposition meriting a double take is mentioned almost in passing:

It is possible that the IRS could name any reliance on such state law tax provision enacted to avoid the federal limitation on the deduction for state and local taxes as a "listed transaction" that will require the taxpayer to disclose such transactions on the federal income tax returns. Preparers of tax returns claiming such deductions may have independent tax preparer reporting obligations.

The IRS defines listed transactions in its regulations (1.6011-4) addressing when taxpayers are required to disclose their participation in any one of several categories of reportable tax arrangements as follows: “A listed transaction is a transaction that is the same as or substantially similar to one of the types of transactions that the Internal Revenue Service (IRS) has determined to be a tax avoidance transaction and identified by notice, regulation, or other form of published guidance as a listed transaction.” 

Treasury and the IRS currently recognize 35 listed transactions, but include this note in the instructions on the Form 8886 disclosure statement: “The fact that a transaction must be reported on this form does not mean the tax benefits from the transaction will be disallowed.” 

“Number one: No one in the IRS has said that there’s going to be a listed transaction. In the literature, nobody’s said that yet, either,” according to Steve Wlodychak of EY, who participated in the development of the AICPA issue paper. “We just wanted to put it out there as the outlier of what the IRS could do within the arsenal of the various tools it has,” he said.

The attorneys general of New York, New Jersey, and Connecticut — the states most aggressively adopting SALT cap workarounds and bringing legal challenges against the federal government — all declined to comment on a Big 4 accounting firm adviser implying that their states might be operating as tax shelter promoters.

“I think the AICPA is right to raise this possibility,” said Duke University law professor Lawrence A. Zelenak, who added in an email to Tax Notes that listed transactions are not synonymous with abusive tax shelters. “Although one tends to think of listed transactions as necessarily ‘abusive,’ the relevant regulation gives the IRS the authority to list any transaction it determines to be a ‘tax avoidance transaction,’” he added. “The ‘tax avoidance’ label — although not exactly a badge of honor — doesn’t necessarily imply that the strategy is abusive or that it doesn’t work.”

Zelenak highlighted the opening paragraph of 1.6011-4(a), which says, “The fact that a transaction is a reportable transaction shall not affect the legal determination of whether the taxpayer’s treatment of the transaction is proper.”

“So, this isn’t really a case of anyone implying that states are promoting abusive shelters,” Zelenak said. But the optics could still be problematic for states adopting SALT cap workarounds, he said, because “the distinction between a tax avoidance transaction and an abusive shelter may be lost on the general public.”

New Assertion

The AICPA issue paper says it’s an open question whether entity-level taxes enacted by states as part of a SALT cap workaround would, in fact, be deductible by a passthrough at the federal level. That’s a new assertion.

The very idea behind the strategy of imposing state tax at the entity level and providing a corresponding credit for the entity’s members is to take advantage of the Tax Cuts and Jobs Act’s preservation of the deduction for state and local taxes paid or accrued in carrying on a trade or business. Proponents argue that by shifting the incidence of the state tax from the owners to the entity, the passthrough would be held harmless for the entity-level state tax — this is because, in theory, the entity-level state tax would be fully deductible for the passthrough at the federal level. The entity’s owners, meanwhile, would get around the $10,000 federal limit on the SALT deduction by virtue of the state credit for their pro rata share of tax paid by the entity.

For example, under Connecticut’s new law, the state will impose a 6.99 percent tax on the net income of partnerships, limited liability companies, and S corporations. Owners will receive a credit against their state income tax liability at a rate of 93.01 percent of their distributive share of tax paid at the entity level. “It works, and we can’t see any way that there’s any credible argument the federal government could make — IRS or otherwise — to disallow this,” then-Revenue Commissioner Kevin Sullivan said in February

The AICPA issue paper suggests otherwise, however. “Deductibility of such [passthrough entity-level] taxes for federal income tax purposes remains an open issue and partners, members and shareholders of PTEs could face challenges from the IRS as to the deductibility of overall income passed through to them from the PTE,” the paper says, later adding, “As of now, no state has provided for financial indemnification for any such challenge by the IRS.”  

“The IRS could apply a quid pro quo challenge to the PTE-level tax approach, similar to that which it has made in proposed regulations challenging the state tax credits for charitable contributions,” according to the paper. “Further, some commentators have suggested that if the IRS continues to challenge approaches to address the limitations on the state tax deduction, IRS may consider challenging the economic substance or substance over form of a transaction.”

Wlodychak cited a footnote in the TCJA conference report that he believes casts doubt on whether the IRS would respect a workaround structure involving entity-level taxes and state credits. The conference report describes how, pre-TCJA, the SALT deduction worked. Individuals, for example, were allowed the deduction for property taxes, ”if incurred in connection with property used in a trade or business; otherwise they are an itemized deduction.”

“In the case of State and local income taxes, the deduction is an itemized deduction notwithstanding that the tax may be imposed on profits from a trade or business,” the TCJA conference report says. That  sentence is followed by footnote 168, which directs readers to a House Report accompanying a 1944 individual income tax bill.

“Now, the tax geek that I am, I went back to look at it,” Wlodychak said.

The 1944 tax law simplified the individual income tax by creating the standard deduction and “the new concept ‘Adjusted gross income.’” In describing how AGI is computed, the 1944 conference report said that deductions made from gross income in arriving at AGI typically are limited to certain business expenses and losses that are treated as losses from sales or exchanges of property.

“The connection contemplated in this statute is a direct one rather than a remote one,” the 1944 report said. “For example, property taxes paid or incurred on real property used in the trade or business would be deductible, whereas State income taxes, though incurred as a result of business profits, would not be deductible.”

Wlodychak said that, read carefully, the TCJA conference report — via its reference to the 1944 report — is connecting old principles of tax law to distinguish between a tax on a passthrough entity that is truly related to business, and a tax on a passthrough entity that is related to personal income. As Wlodychak sees it, the TCJA conference report is making the point that the IRS’s long-standing position is that an income-based tax is outside the realm of the business activity of a passthrough entity. Such a distinction suggests that a tax related to the income of the owners would be included within the TCJA’s $10,000 cap on the SALT deduction, Wlodychak said, adding that he believes Connecticut’s entity-level tax arrangement as a workaround would thus be suspect.

“I don’t see any difference between the quid pro quo approach as it applies here,” Wlodychak said. “Keep in mind, we are in uncharted territory, because we have never had a limitation on the SALT deduction. I don’t know how the courts are going to approach this from a taxability analysis. But it seems very clear that the Congress intended the limitation to apply at the entity level with respect to income earned by taxpayers.”  

Treasury Secretary Steven Mnuchin and House Ways and Means Committee Chair Kevin Brady, R-Texas, earlier this year publicly called the SALT cap workaround involving state credits and charitable contributions “ridiculous” and “a gimmick,” respectively. Treasury and the IRS in May also indicated that they are monitoring other SALT cap workaround proposals to ensure that federal law controls the characterization of deductions for federal income tax purposes. 

“All of these are ominous signals to me that the IRS is going to aggressively pursue any of these arrangements that are intended to get around the SALT deduction, and I advise clients to be cautious until we have clear guidance,” Wlodychak said.

Tax Shelter Schemes?

According to Wlodychak, Zelenak’s writing influenced the panels that developed the AICPA issue paper. Specifically, Zelenak this summer called the SALT cap workaround strategy involving credits against state taxes for contributions to government organizations a “tax shelter scheme” that converts taxes subject to the $10,000 limit to charitable contributions.

“The conversion strategy is a kind of tax shelter, and tax shelters that appear to work under a hypertechnical analysis often fail under one or more antiabuse rules, including the judge-made substance-over-form doctrine and the closely related economic substance doctrine,” Zelenak wrote. His article was prompted in part by a widely circulated research paper by eight law professors — the lead author is Joseph Bankman of Stanford Law School — that argues the legality of taxpayers claiming the federal charitable contribution deduction for donations for which they’ve also received a state tax credit.

Bankman and Darien Shanske of the University of California, Davis, one of the coauthors of the original research paper, responded one month later.

“It can be argued that the states are in the position of tax shelter promoters, and benefits to promoters are ignored in determining whether a transaction has substance under common law doctrines,” Bankman and Shanske wrote. “The analogy is not quite right, though.” 

It’s not just that the states are not the same as the corporate tax shelter industry, they wrote — among other things, the states are sovereign, act on behalf of their citizens, and are not subject to tax. According to Bankman and Shanske, the primary reason it was necessary to apply doctrines like substance over form to corporate tax shelters was because the arrangements could not be addressed through legislation. “The shelters were developed in secret and often took years to come to the attention of the IRS, and still longer before legislation could prospectively reduce their benefits,” they wrote. 

That is not the case with the states, Bankman and Shanske wrote. The SALT cap workarounds involving charitable donations and state tax credits are based on existing programs, “and new donation credit proposals have received enormous publicity.” 

“The credit proposals at issue, unlike conventional tax shelters, were motivated by concern for the body politic and have been accompanied by public debate and analysis,” Bankman and Shanske wrote. “We simply do not know how a benefit to the state, and corresponding benefit to its citizens, does or should fit into the substance leg of common law doctrines.”

Another Take

After Connecticut adopted its entity-level tax arrangement, Parity for Main Street Employers — a coalition of businesses organized as passthroughs — released model state legislation for the SALT cap workaround.   

“According to the Joint Committee on Taxation, the tax hike from the loss of the SALT deduction is significantly bigger than the benefit of the 20-percent pass-through deduction,” Chris Smith, the coalition’s executive director, said in May

According to the AICPA issue paper, officials in at least three more states — New York, New Jersey, and Arkansas — have since indicated that they’re also interested in such an approach. Now might be a good time to clarify in an aside that most of the AICPA issue paper has nothing to do with the question of whether the SALT cap workaround is a shelter or should be a listed transaction. For example, the paper lists several potential benefits of entity-level tax proposals, including a simplified determination of nexus at the entity level, rather than at the individual owner level, which also would reduce compliance costs for multi-tiered entities.

“The AICPA does not take any position on these state tax proposals, either as a concept or on any of the specific legislative drafts that some states have recently released,” the issue paper says in bold letters. Wlodychak, meanwhile, described the paper as a collection of thoughts about the state and local tax deduction that might help guide CPAs in state societies when such passthrough entity-level tax arrangements are proposed.

Brian Reardon, president of the S Corporation Association, praised the AICPA’s analysis of the 13 states and localities that already impose some type of entity-level tax on passthrough businesses. “Nobody’s arguing that those taxes wouldn’t be deductible under the new tax reform regime,” he said.

Also, Treasury and the IRS have never mentioned the entity-level state tax strategy in their commentary on proposed SALT cap workarounds, even though Connecticut has already passed a version. “I feel like if there were a strong position for them to take against this, they would’ve already been making efforts and noises,” Reardon said. 

Superficially, there might be a resemblance between an arrangement involving an entity-level tax and a corresponding credit for the owners on their pro rata share of tax paid by the passthrough, and SALT workarounds involving credits in exchange for contributions to government charities, Reardon said. “But I think we’re on much surer ground. You’re taking a tax payment made by an individual and making it a payment by an entity instead — so, it’s still a tax payment, you’re just changing the incidence of the tax.”

Reardon added that the law is clear that if the tax is paid by the entity, it’s deductible; if the tax is paid by the owners, then it’s subject to the new $10,000 cap. He cited footnote 172 in the TCJA conference report, which says: “Taxes imposed at the entity level, such as a business tax imposed on pass-through entities, that are reflected in a partner’s or S corporation shareholder’s distributive or pro-rata share of income or loss on a Schedule K-1 (or similar form), will continue to reduce such partner’s or shareholder’s distributive or pro-rata share of income as under present law.”  

Reardon also cited the clarification issued by Treasury and the IRS shortly after the release of the proposed regs addressing state tax credits and charitable contributions. “The business expense deduction is available to any business taxpayer, regardless of whether it is doing business as a sole proprietor, partnership or corporation, as long as the payment qualifies as an ordinary and necessary business expense,” the clarification says. “Therefore, businesses generally can still deduct business-related payments in full as a business expense on their federal income tax return."

“That clarification, in my mind, strengthened the case that we have,” Reardon said. “We’re not trying to pretend that a tax is a charitable contribution. We’re simply saying that if the new rule is that entity-level taxes are deductible and shareholder taxes are not, then states should look to impose these taxes at the entity level and make them deductible.”

Reardon added that it’s patently unfair that under the TCJA, C corporations can continue to deduct state and local taxes, but an S corporation cannot.

“There’s no reasonable, underlying policy rationale for that,” Reardon said. ”Until we can fix this at the federal level, I think it’s perfectly appropriate for states to address it on their own."

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