Menu
Tax Notes logo

IRS Working on Guidance for Applying SALT Cap to Passthroughs

Posted on July 23, 2019

Treasury and the IRS are developing proposed rules on the application of the $10,000 cap on the state and local tax deduction to passthroughs, and practitioners fear the guidance will seek to invalidate an emerging SALT cap workaround.

The latest IRS-Treasury priority guidance plan includes an item on applying the  section 164(b)(6) SALT deduction cap to passthrough entities. Despite having also appeared on the priority guidance plan in November 2018, the project has largely flown under the radar — although in recent weeks officials have increased the number of meetings they are having with practitioners on the subject. 

Treasury and the IRS initially sought to release a notice of proposed rulemaking on the SALT cap’s application to passthroughs by June 29, according to planning documents for Tax Cuts and Jobs Act guidance projects obtained by Tax Notes this spring through a Freedom of Information Act request. 

Deadlines in the informal planning documents have proved ambitious regarding several TCJA guidance projects. While a notice of proposed rulemaking on the SALT cap and passthroughs is not imminent, practitioners say they expect one in the next few months.

In the June 11 final regulations (T.D. 9864) ending the SALT cap workarounds involving state tax credits in exchange for charitable contributions, Treasury and the IRS discussed passthrough-related issues raised by commentators. The section, “Application of Section 162 for Business Taxpayers,” said a key concern derives from the fact that under the TCJA, the $10,000 cap on the SALT deduction applies only to individuals. Taxpayers engaged in a trade or business can in some instances claim a section 162 deduction for amounts paid to section 170 charitable or government entities as ordinary and necessary business expenses.

“A few commenters opined that the proposed regulations further escalate the disparate treatment of charitable contributions by individual wage earners as compared to similar contributions by passthrough entities and their members who are individuals,” the final regs said. Commentators noted that the SALT cap does not apply to state or local real or personal property taxes paid or accrued in carrying on a trade or business, or to an activity described in section 212 addressing expenses for the production of income — and that this exception, combined with the availability of business expense deductions under section 162, means that a taxpayer-owner of a passthrough will continue to receive the benefits of an allocable share of tax credits received by the entity. 

“In addition, commenters pointed out that several states have enacted or considered enacting legislation that shifts state taxes from individuals to passthrough entities and entitles the owners to claim a credit on the owner's state tax return for the amount of the owner's distributive share of taxes paid by the passthrough entity,” the final regs said. 

Connecticut last year became the first state to take advantage of this aspect of the TCJA by enacting a SALT cap workaround featuring a mandatory entity-level state income tax on the net receipts of passthroughs and an offsetting state tax credit for the entity’s members. Developed by the Connecticut Department of Revenue Services, the idea behind the workaround is that the entity-level state tax is deductible by the passthrough and reduces the distributive share of the tax payment passed on to members, which would be offset by the newly created state individual income tax credit. Most states provide a deduction for such a payment but not a separate tax credit. 

Wisconsin adopted its own version of the passthrough workaround strategy in December 2018, and Louisiana, Oklahoma, and Rhode Island have recently followed. The plans adopted by those four states differ from Connecticut’s in that the entity-level state tax on passthroughs is optional rather than mandatory.

“From both public statements and private conversations we’ve had with Treasury officials, we are concerned that the upcoming proposed regulation may attempt to include these new passthrough entity tax workarounds as another attempt to avoid the section 164 SALT cap,” said Bruce Ely of Bradley Arant Boult Cummings LLP, an expert in the state taxation of passthroughs.

Steve Wlodychak of EY said he suspects "the target will be the state ‘substitute’ taxes, like Connecticut’s passthrough entity tax.”

“The issue is whether those taxes are ‘stand-alone’ deductible business taxes at the entity level or a substitute for a state’s personal income tax,” Wlodychak said, adding that the latter would not be deductible at the federal level. The question is how Treasury and the IRS would define which entity-level state taxes are serving as a substitute for a state’s individual income tax without sweeping up entity-level state taxes that are not part of a strategy to circumvent the SALT deduction limitations, he said.

Treasury has to thread a very fine needle here,” Wlodychak said.

Trade or Business Issues

Treasury and the IRS alerted taxpayers last year that they are monitoring additional types of SALT cap workarounds in the states, and officials this spring expressed skepticism about the strategies involving state entity-level taxes on passthroughs and offsetting credits for members — although IRS Chief Counsel Michael Desmond recently said the IRS hasn’t decided how it will respond to the new approaches.

Even if states weren’t adopting the new workaround, Treasury and the IRS still need to issue guidance on how the SALT cap applies to passthroughs, said Brian Reardon, president of the S Corporation Association. The association advocates for adoption of the new SALT cap workarounds as a way for states to provide parity to passthroughs.

 “If you’re going to take SALT deductions as a legitimate business expense, you have to be a trade or business, and this just puts increased pressure on that definition,” Reardon said.

Property taxes, for example, are widely imposed by states at the entity level. Reardon said whether an entity-level property tax paid by an individual owner of an S corporation is deductible at the federal level will depend on whether that S corporation is considered a true trade or business by Treasury and the IRS. “They’re going to have to think through a lot of this, regardless of whether states are taking action to create entity-level options,” he said.

Treasury and the IRS acknowledged that the final regs on charitable contributions might raise more questions about the application of trade or business expenses under section 162 and the SALT cap to entities making contributions to charities or government foundations and receiving a state or local tax credit in return. The authors of the final regs noted that in December 2018, the IRS issued Rev. Proc. 2019-12 to clarify that C corporations and specified passthrough entities making charitable contributions in exchange for state tax credits can continue to deduct those payments as ordinary and necessary business expenses; Treasury and the IRS refer to this clarification as a safe harbor.

Regarding commentator concerns about the disparate treatment of charitable contributions made by individuals and passthroughs, Treasury and the IRS said that under the final rules, businesses — like individuals — also must reduce their charitable contribution deduction by the amount of any benefit they receive or expect to receive. Those concerns thus are not arising from disparate treatment of taxpayers under the section 170 charitable contribution rules, Treasury and the IRS said, but from the application of trade or business expenses under section 162 and the section 164 SALT cap to passthrough entities and their owners.

Treasury and the IRS will continue to study comments involving the effect of the final regulation on various business entities and will provide additional guidance as needed,” the final regs said.

Ely, who represents several scholarship-granting organizations in the Southeast, said practitioners are asking Treasury to clarify that a passthrough receiving a state income tax credit in return for a donation to a qualified scholarship organization can deduct the donation when it qualifies as a section 162 or section 212 expense and the entity passes the credit through to members — including individuals.

“The current revenue procedure safe harbor only allows C corp donors to deduct the donation for federal tax purposes while claiming the state or local income tax credit, and 'specified passthrough entity' donors if they likewise qualify under the 162/212 safe harbor,” Ely said. He added that the latter category was limited — both in the December clarifying revenue procedure and in the preamble to the final regs — to donations generating a credit for an entity-level tax, such as a property or excise tax. That is, the safe harbor does not apply to a state income tax credit, he said.

“We don't see why the same trade-or-business expense test shouldn't apply to passthrough entity donors as it does to C corporation donors," Ely said.

Reardon said that both the June final regs and the December clarification strengthen arguments regarding the legality of the passthrough SALT cap workarounds.

“The same arguments and position that Treasury takes with regard to the charitable contributions SALT cap workaround and the section 162 deduction for trade or business expenses can be applied to what we’re doing,” Reardon said. The state taxes on individuals that would be capped under the section 164 SALT limitation are now imposed on and paid by the entity, and should be deductible under section 162 as a trade or business expense, he said. “I think our arguments are stronger, because we’re not taking a tax and making it look like a charitable contribution — we’re taking a tax and changing the incidence of the tax.”

“The only difference is that in regard to charitable contributions and the section 162 deduction for trade or business expenses, the taxpayer has to separate out from its federal deduction any benefit it is getting back from the contribution,” Reardon added. “Here, the full tax is deductible. There’s nothing to subtract out.”

It’s also unclear under what legal rationale Treasury and the IRS would determine that an entity-level state tax is no longer a legitimate business expense deductible by a passthrough, Reardon said.

Listed Transaction?

The American Institute of CPAs said in an issue paper last year that it’s an open question whether state entity-level taxes on passthroughs enacted as part of a SALT cap workaround are deductible for federal income tax purposes. The paper examines the potential benefits and risks of the passthrough entity-level state tax workarounds, to assist state societies of CPAs in analyzing proposals in their jurisdictions.

The AICPA authors surmised that the IRS and Treasury could make the new SALT cap workaround a listed transaction, which would require taxpayers to report their participation in such arrangements to the IRS. While no official has said the government is considering doing that, Wlodychak, who helped develop the AICPA paper, told Tax Notes last year that the authors “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.” 

The IRS also could apply a quid pro quo challenge to the passthrough SALT cap workarounds, as it did with the charitable contribution strategies, the AICPA paper said. “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.”

Ely and Reardon both said the passthrough SALT cap workarounds are on solid legal ground, but they acknowledged theories that the IRS and Treasury might have a better shot at invalidating strategies involving optional rather than mandatory entity-level state tax. 

“The tax code is full of elections,” Reardon said. “But once you make the election, you still owe the tax. That doesn’t change the nature of the tax itself.”

Reardon’s association and Parity for Main Street Employers — a coalition of businesses organized as passthroughs — are circulating a memo providing a legal analysis of Wisconsin’s entity-level tax SALT cap workaround and, more generally, the legal foundation supporting such strategies. The author is Thomas Nichols of Meissner Tierney Fisher & Nichols SC, who helped develop Wisconsin’s law.

The TCJA's legislative history clearly indicates that the SALT deduction cap does not apply to state and local taxes imposed on passthrough entities, Nichols wrote. The conference committee report to the TCJA “explicitly reiterated and relied upon this principle in describing the scope” of the new SALT deduction, he said.

Specifically, regarding the final section 164(b)(6) provisions, the TCJA conference report stated: “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.” 

That statement is consistent with IRS guidance, Nichols said. In Rev. Rul. 58-25, the IRS held that a Cincinnati tax on net profits “imposed upon and paid by a partnership” is deductible in computing the taxable income of the partnership, he said. In Rev. Rul. 71-278, the IRS ruled that an Indiana tax imposed on gross income at the partnership level is deductible from partnership gross income “in computing the taxable income of a partnership and the distributable shares of the partners.”

“Significantly, both of the above rulings specifically noted that the deduction of these taxes at the entity level did not preclude the individual partners in these partnerships from claiming the standard deduction, which would have been the case if the tax imposed at the partnership level were separately stated and passed through to be treated as an itemized deduction at the individual level,” Nichols said.

Nichols later added that “there are no cases or rulings holding that a state income tax imposed at the pass-through entity level is to be passed through separately and subject to standard deduction or other limitations upon deductibility at the individual level.”

According to Nichols, the IRS “has consistently held that income and other taxes imposed upon and paid by pass-through entities are simply subtracted in calculating nonseparately computed income at the entity level, and are not separately passed through or incorporated into the various provisions and calculations applicable to itemized deductions at the individual level.”

Finally, Nichols described some of the long-standing entity-level taxes imposed by states or cities and their federal tax treatment. The District of Columbia imposes entity-level income tax on S corporations and an entity-level unincorporated business franchise tax on partnerships, he said. Pennsylvania allows S corporations to opt out of passthrough treatment for its state income tax. Georgia, Mississippi, New Jersey, and New York require some form of affirmative election or consent to qualify for S corporation passthrough treatment. “Finally, Alabama, California, Illinois, Kentucky, New Hampshire, New York City and Tennessee have also had income taxes imposed at the entity level for some time,” he wrote.

“All of these entity-level income taxes have been consistently deducted in calculating nonseparately computed income passed through to the owners for federal income tax purposes, and have not been treated as state income taxes paid at the individual level so as to trigger disallowance of the standard deduction, alternative minimum tax disallowance and/or the Pease reduction,” Nichols wrote. “It has not been suggested that the treatment of these taxes has somehow been changed by the Tax Cuts and Jobs Act."

Copy RID