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Rethinking the State and Local Business Tax Deduction

Posted on Nov. 29, 2021
[Editor's Note:

This article originally appeared in the November 29, 2021, issue of Tax Notes Federal.

]
Alan D. Viard
Alan D. Viard

Alan D. Viard is a senior fellow emeritus at the American Enterprise Institute. He thanks Alex Brill, Kyle Pomerleau, Grant Seiter, Sita Slavov, and participants in the Tax Economists Forum for helpful comments.

In this article, Viard examines the federal tax deduction for state and local business taxes, and he analyzes reform options that can narrow or eliminate the preferential treatment for some business taxes.

The views expressed here are solely the author’s and do not necessarily reflect those of any other person or institution.

Copyright 2021 Alan D. Viard.
All rights reserved.

The federal tax system generally allows an uncapped above-the-line deduction for state and local business taxes while providing (at most) a capped itemized deduction for other state and local taxes. Surprisingly, the state and local business tax deduction has received little scrutiny.

I assess the federal tax treatment of business and nonbusiness taxes. The uncapped above-the-line deduction for business remittances of state and local sales and excise taxes doesn’t result in preferential federal tax treatment of those taxes. However, some state and local business taxes, including employer payroll taxes and entity-level passthrough business income taxes, receive preferential federal tax treatment. I review reform options that could narrow or eliminate the disparate federal tax treatment and examine potential obstacles to reform.

I. State and Local Tax Deduction

Section 164 allows individuals and C corporations to deduct some taxes paid to states and their political subdivisions. Under sections 164(b)(2) and 7871(a)(3), the deduction also applies to taxes paid to the District of Columbia and tribal governments. Those taxes are generally referred to as state and local taxes.1

Section 164(a) allows a deduction for state and local taxes, other than property and income taxes, which are incurred in carrying on a trade or business or an activity to produce income. A deduction is also allowed for real property taxes under section 164(a)(1), personal property taxes under section 164(a)(2), and income taxes (including war profits taxes and excess profits taxes) under section 164(a)(3). Under section 164(b)(5), individuals may elect to deduct state and local general sales taxes, but not selective excise taxes, in lieu of deducting state and local income taxes.2

C corporations may claim an above-the-line deduction for property taxes, income taxes, and other taxes incurred in carrying on a trade or business or an activity to produce income. For simplicity, I assume that all taxes paid by C corporations fall into those categories.

Individuals, however, may claim an above-the-line deduction for only two types of taxes. Section 62(a)(1) allows individuals to claim an above-the-line deduction for state and local taxes that “are attributable to a trade or business carried on by the taxpayer, if such trade or business does not consist of the performance of services by the taxpayer as an employee.” Section 62(a)(4) provides a similar dispensation for state and local taxes that “are attributable to property held for the production of rents or royalties.”

Individuals’ payments of other state and local taxes listed in section 164 give rise to itemized deductions, which are unavailable to individuals who claim the section 63 standard deduction. Moreover, under section 56(b)(1)(A)(ii), income, sales, and property taxes that aren’t allowed as above-the-line deductions are disallowed under the individual alternative minimum tax.

The above-the-line deduction for state and local taxes incurred in carrying on a trade or business (other than providing services as an employee) or an activity to produce rental and royalty income doesn’t apply to state and local individual income taxes on the income derived from those pursuits. Reg. section 1.62-1T(d) counterintuitively decrees that state individual income taxes imposed on income from carrying on a trade or business are nonbusiness taxes. In Part II.C of the article, I examine the rationale for that rule.

The Tax Cuts and Jobs Act, enacted December 22, 2017, placed a cap on individuals’ deductions for state and local taxes. Under section 164(b)(6), the TCJA cap applies to state and local real and personal property taxes, unless the taxes were paid or incurred in carrying on a trade or business or an activity to produce income, and to state and local income taxes (or to state and local sales taxes deducted in lieu of income taxes).

At the time of this writing, the TCJA cap is equal to $10,000 and is applicable to 2018 through 2025.3 As part of the fiscal 2022 budget reconciliation process, Congress is considering changes to the dollar value of the cap and the years to which it is applicable.

The table summarizes the federal tax treatment of individuals’ state and local tax payments.

Type of State and Local Tax Payment by Individuals

Federal Tax Treatment

Taxes connected to non-employee trade or business or production of rental and royalty income

Above-the-line deduction, allowed under AMT, uncapped

Income taxes (or general sales taxes) and property taxes, not connected to non-employee trade or business or production of rental and royalty income

Itemized deduction, disallowed under AMT, subject to TCJA cap

Other taxes, not connected to non-employee trade or business or production of rental and royalty income

No deduction

I use the term “business taxes” to refer to C corporations’ state and local tax payments and to individuals’ payments of state and local taxes listed in the first row of the table. Those taxes receive an uncapped above-the-line deduction. I use the term “nonbusiness taxes” to refer to individuals’ payments of state and local taxes listed in the second and third rows of the table. Tax payments listed in the second row receive a capped itemized deduction.

The uncapped above-the-line deduction for state and local business taxes has received relatively little scrutiny. As professor Louis Kaplow of Harvard Law School has noted, the deductibility of individuals’ state and local tax payments is “intensely controversial,” while it is “generally taken for granted that business taxes should be deductible by the businesses that pay them.”4 The Office of Management and Budget and the Joint Committee on Taxation classify the itemized deduction for state and local income, property, and sales taxes as a tax expenditure while classifying the deduction for state and local business taxes as part of the normal tax structure.5

Proposals to limit itemized deductions, including the deduction for state and local nonbusiness taxes, often don’t include any changes to the above-the-line deduction for state and local business taxes. For example, the Congressional Budget Office included the repeal of itemized deductions, with no changes to the deduction of state and local business taxes, on a recent list of deficit-reduction options.6

Still, the state and local business tax deduction has drawn some attention. In its income tax reform plan, the 2005 President’s Advisory Panel on Federal Tax Reform recommended that the deduction for state and local income taxes be repealed for large businesses.7 News reports in early 2020 stated that external advisers to the Trump administration were discussing a cap on the state and local business tax deduction.8 Recently, Michael Knoll of the University of Pennsylvania Law School recommended disallowing the deduction for state and local corporate income tax payments,9 and my American Enterprise Institute colleague Kyle Pomerleau stated that a cap on state and local corporate tax payments could be a better option than reinstating the corporate AMT.10 Kimberly Blanchard of Weil, Gotshal & Manges has condemned the “folly” of proposals to deny individuals the state and local tax deduction while allowing the deduction for businesses.11 The Committee for a Responsible Federal Budget recently listed the extension of the TCJA cap to businesses as a revenue-raising option.12

Nevertheless, the discussion of the state and local business tax deduction has been sparse compared with the extensive discussion of the itemized deduction for state and local nonbusiness taxes. In this article, I explore the economics of the business tax deduction.

II. Simplified Framework

It is hard to see why the federal tax system should provide favorable treatment for state and local (hereafter “state”) business taxes because Congress presumably doesn’t intend to encourage states to impose business taxes. Therefore, I assume that the two types of taxes should receive similar federal tax treatment and examine whether the system deviates from that objective.

At first glance, the answer may seem obvious. The uncapped above-the-line deduction for state business taxes appears to offer more generous treatment than the capped itemized deduction for selected state nonbusiness taxes. The latter deduction, after all, is unavailable to taxpayers who claim the standard deduction, are subject to the AMT, or are above the TCJA cap. However, careful analysis reveals a more complicated picture. State business taxes do not always receive favorable federal tax treatment. Moreover, when favorable treatment occurs, it isn’t always a direct result of the uncapped above-the-line deduction.

I begin by using a simplified framework to consider three types of state taxes. First, I examine state sales and excise taxes under the simplifying assumption that they are shifted to buyers through higher prices. In that case, the uncapped above-the-line deduction that the sellers may claim for their tax remittance doesn’t provide favorable treatment and is instead necessary to offset the tax on the additional gross receipts attributable to the higher prices.

Second, I examine state employer payroll taxes under the simplifying assumption that they are shifted to employees through lower wages. Those taxes receive favorable federal tax treatment relative to state wage taxes imposed on employees. However, the favorable treatment arises from the combination of the uncapped above-the-line deduction and the implicit deduction that employees receive for their wage reduction, not from the former deduction alone.

Third, I examine state taxes on passthrough business income under the simplifying assumption that the tax burden is borne by the business owners. The uncapped above-the-line deduction for entity-level business income taxes inappropriately favors those taxes over economically similar owner-level business income taxes.

A. State Sales and Excise Taxes

I first consider state destination-based sales and excise taxes, under the assumption that they are shifted to customers in the form of higher prices. I briefly discuss potential modifications of that assumption in Section III.

If the business seller is taxed on the additional gross receipts attributable to the price increase caused by the state sales or excise tax, an uncapped above-the-line deduction for the offsetting tax payment doesn’t provide any net federal tax savings. Instead, the deduction merely offsets the net federal tax increase that would occur if the additional gross receipts were taxed with no offsetting deduction. Moreover, because the buyers who pay the higher prices don’t experience any reduction in their adjusted gross incomes, there is no change in their federal tax liabilities, apart from any itemized deduction that may be allowed for their payments of the higher prices.

The only net federal tax savings, therefore, arise from any itemized deduction that the buyers may receive, not from the business’s above-the-line deduction. The uncapped above-the-line deduction is clearly warranted in that context.

To understand the appropriate treatment of a state sales or excise tax, it is useful to consider three mechanisms for administering the tax. The mechanisms differ depending on the seller’s role.

First, suppose that buyers are required to remit the sales or excise tax directly to the state treasury without any involvement by the seller. In that case, the state tax wouldn’t appear on the seller’s federal tax return and wouldn’t affect the seller’s federal tax liability. If Congress does not allow the buyers a deduction for their tax remittances, the imposition of the state tax gives rise to no federal tax savings. If Congress allows the buyers an itemized deduction, the only federal tax savings arise from that deduction, not from the tax treatment of the seller.13

Second, suppose that the state imposes the legal liability for the sales or excise tax on the buyer but requires that the seller collect the tax from the buyer (in addition to the tax-exclusive price) and remit the tax to the state treasury. Because the seller serves as a mere conduit for the tax payment, there is no substantive change from the case in which buyers directly remit the tax. As before, the state tax should not appear on the seller’s federal tax return or affect the seller’s federal tax liability. Today’s law prescribes exactly that treatment. In accord with reg. section 1.448-1T(f)(2)(iv), the IRS instructs businesses, “State and local sales taxes imposed on the buyer that you were required to collect and pay over to state or local governments . . . are not included in gross receipts or sales nor are they a deductible expense.”14

Ignoring the collection and remittance of the state sales or excise tax on the seller’s federal tax return doesn’t provide any net federal tax savings. Instead, the only federal tax savings are those arising from any itemized deduction allowed to the buyer. (As discussed above, an itemized deduction for state general sales taxes, but not state selective excise taxes, is available under section 164(b)(5) in lieu of the deduction for state income taxes.) Withholding taxes, for which the withholding party similarly serves as a mere conduit, also don’t appear on that party’s tax return. For example, when employers withhold state income taxes from their employees’ paychecks, the employer doesn’t include the withheld funds in its gross receipts or deduct the remittance of the funds to the state treasury.

Third, suppose that the state imposes the legal liability for the sales or excise tax on the seller. Because the formal change in legal liability does not alter the real economic equilibrium, the gross price charged by the seller is the same as the tax-inclusive price charged when the buyer was legally liable. The federal tax treatment should therefore be the same for the tax legally imposed on the seller as it is for the tax legally imposed on buyers and the tax that the buyers directly remitted to the state treasury. Today’s law provides essentially the same treatment, although in a slightly different form. In accord with reg. section 1.448-1T(f)(2)(iv), the IRS instructs businesses, “You can deduct . . . state and local sales taxes imposed on you as the seller of goods or services. If you collected this tax from the buyer, you must also include the amount collected in gross receipts or sales.”15 The state sales or excise tax appears in two offsetting items on the seller’s federal tax return, namely an inclusion of the gross receipts from the higher gross price and a deduction for the tax payment.16

The third case is the only one in which the seller is allowed an explicit deduction. However, the allowance of the uncapped above-the-line deduction in that case is equivalent to, and achieves the same neutral outcome as, the treatment provided in the first two cases. Although the allowance of an uncapped above-the-line deduction appears generous, it does not give rise to any net federal tax savings from the state tax payment. As before, the only federal tax savings arise from any itemized deduction provided to the buyers.17

The uncapped above-the-line deduction for the state sales or excise tax merely offsets the increase in federal tax liability that would otherwise occur from the increase in nominal income triggered by the state tax. The price increase caused by the state tax increases the seller’s nominal gross receipts without reducing the buyers’ nominal gross incomes. The seller’s deduction merely protects the seller from a federal tax increase and does not provide any net federal tax savings. Aside from any itemized deduction, the buyers receive no federal tax savings for the state tax burden that they bear. Although the state tax reduces their real incomes, it does so through a price increase rather than a reduction in nominal incomes. There are no automatic federal tax savings from the buyers’ payments of higher prices to the sellers, just as there are none when buyers directly remit the tax to the state treasury.18

Other commentators have made this point. Knoll notes that the “business is left with the same net income” after the deduction and that the buyer’s payment of higher prices is nondeductible.19 Kaplow similarly observes that the seller’s deduction merely offsets its higher gross receipts.20

B. State Employer Payroll Taxes

I next consider state employer payroll taxes, under the assumption that they are shifted to employees in the form of lower wages. I briefly discuss potential modifications of that assumption in Section III.

Suppose that the imposition of a $100 state employer payroll tax causes wages to fall by $100. In isolation, the employer’s above-the-line deduction for its state payroll tax payment seems appropriate, just as it did for state sales and excise tax payments. The imposition of the payroll tax triggers a reduction in the employer’s wage costs and therefore in its wage expense deduction. If the employer could not deduct its tax payment even as its wage expense deduction was reduced, its federal tax liability would be higher than if the state payroll tax had not been imposed. The employer would face a net federal tax increase simply because it served (in economic terms) as a conduit for the payment of a tax that ultimately burdened employees. Looking at the business in isolation, the above-the-line deduction merely allows the business to pay the same federal taxes as it would have done in the absence of the state payroll tax and therefore generates no net federal tax savings.

However, that analysis is incomplete because it ignores the federal tax treatment of the employees. Because the employees have $100 less in wages on which to pay federal income tax, they receive a $100 automatic implicit federal income tax deduction. The automatic implicit deduction is effectively an uncapped above-the-line deduction because it is applicable to employees even if they claim the standard deduction, are subject to the AMT, elect to deduct state sales taxes in lieu of state income taxes, or are above the TCJA cap. Moreover, the automatic implicit deduction is also available under the federal payroll tax because the employees have $100 less in wages on which to pay that tax.

State wage taxes imposed on employees, either in the form of individual income taxes or employee payroll taxes, receive much less favorable federal tax treatment. State individual income taxes receive only the capped itemized deduction. State employee payroll taxes and mandatory wage-based contributions to social insurance funds are classified as income taxes and receive the same treatment.21 Moreover, no deduction is available under the federal payroll tax.

Soon after the TCJA was adopted, professor Daniel Hemel of the University of Chicago Law School proposed that states adopt employer payroll taxes, accompanied by offsetting credits that employees could claim against their individual taxes. Hemel acknowledged several potential difficulties posed by such payroll tax swaps, including the treatment of interstate commuters; the need for wages to decline to accommodate the tax swap; and legal challenges to elective tax swaps.22 Hemel estimated that $154 billion of federal tax savings could be obtained nationwide in 2018 through 2025 if every state adopted a payroll tax swap and applied it to all employers.23

However, only New York has adopted a payroll tax swap. It has enacted an elective employer compensation expense tax, with a 1.5 percent tax rate in 2019, 3 percent in 2020, and 5 percent in 2021 and thereafter, with employees of participating employers allowed to claim a credit against their individual tax liabilities.24 Although participation has increased over time, only a tiny fraction of New York employers have elected into the tax.25 Employers may be uncertain about whether they can easily lower wages to accommodate the tax swap.

The recent experience indicates that the disparate federal tax treatment of state employer payroll taxes and state employee wage taxes does not provide states with a quick and easy arbitrage opportunity. Over time, however, the disparate treatment may prompt states to make greater use of employer taxes and less use of employee taxes. In any event, it is hard to imagine a justification for the sharply disparate treatment of two economically similar taxes.

C. State Business Income Taxes

I now consider state taxes on passthrough business income, under the assumption that the business owners bear the tax burden and cannot shift it to other parties. I briefly examine potential modifications of that assumption in Section III.

If an uncapped above-the-line deduction was available for state business income taxes, it would provide considerably more favorable treatment than the capped itemized deduction available for state nonbusiness taxes. Because the state business income tax is not shifted, there is no increase in the business’s before-tax profits, either through the collection of higher prices or the payment of lower wages. There is therefore no increase in the business’s other federal tax liability, for which an uncapped above-the-line deduction for the tax payment would be needed as an offset. The allowance of that deduction for state business income taxes would provide highly favorable treatment of those taxes.

The federal tax system does not allow an uncapped above-the-line deduction for state business income taxes imposed at the owner level. As mentioned above, reg. section 1.62-1T(d) counterintuitively decrees that state individual income taxes imposed on income from carrying on a trade or business are nonbusiness taxes. The regulation offers the following explanation:

To be deductible for the purposes of determining adjusted gross income, expenses must be those directly, and not those merely remotely, connected with the conduct of a trade or business. For example, taxes are deductible in arriving at adjusted gross income only if they constitute expenditures directly attributable to a trade or business or to property from which rents or royalties are derived. Thus, property taxes paid or incurred on real property used in a trade or business are deductible, but state taxes on net income are not deductible even though the taxpayer’s income is derived from the conduct of a trade or business.

Although the rule is counterintuitive, it is long-standing and reflects congressional intent. Although the temporary regulation was adopted in 1988,26 it replaced a permanent regulation, adopted in 1945, that contained identical language.27 A statement with almost identical language appeared in the House and Senate reports accompanying the 1944 tax bill.28

Although the regulation reaches the correct conclusion, its stated rationale is thoroughly unconvincing. How could any tax be more directly related to a trade or business than a tax on the income that it generates?

The regulation says the uncapped above-the-line deduction is denied for business income taxes because they are classified as nonbusiness taxes. The causality more likely runs in the opposite direction. Business income taxes are (counterintuitively) classified as nonbusiness taxes for the purpose of denying them the uncapped above-the-line deduction because that deduction is inappropriate for taxes that the business cannot shift to other parties.

Some commentators who oppose an uncapped above-the-line deduction for state business income taxes similarly use terminology that obscures the true rationale. Knoll argues that income taxes shouldn’t be deductible because “a general income tax is not imposed on a specific type of transaction but applies to all income. In other words, with a comprehensive income tax, the tax is not a cost of earning income but is instead paid out of earned income. . . . General income taxes are uses of income, not costs of earning income.”29 In reality, general income taxes are a quintessential cost of earning income because they apply to, and are triggered by, the earning of all income. Knoll’s actual rationale appears to be that general income taxes aren’t easily shifted because they cannot be avoided by switching among different types of transactions.

If the extent of shifting was recognized as the relevant criterion, entity-level business income taxes would be treated the same as owner-level business income taxes. Assuming that the tax base is specified in the same manner, imposing the tax at the entity level rather than the owner level does not change the extent of shifting.

However, state entity-level taxes are classified by the federal tax system as business taxes, qualifying them for the uncapped above-the-line deduction. The House report accompanying the TCJA reaffirmed that “taxes imposed on 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.”30 The JCT report explaining the TCJA included an almost identical statement.31

The disparate treatment of entity-level and owner-level taxes enables states to reap federal tax savings for their residents by taxing passthrough business income at the entity level rather than the owner level. That strategy would have yielded some gains even before the TCJA because entity-level taxes would have allowed federal tax savings for business owners who claim the standard deduction, are subject to the AMT, or elect to deduct state sales taxes in lieu of state income taxes. However, the ability to avoid the TCJA cap makes the strategy much more attractive.

In the wake of the TCJA, states began to adopt or consider entity-level taxes, accompanied by a credit against business owners’ state individual tax liabilities. In November 2020 Treasury issued Notice 2020-75, 2020-49 IRB 1453, which described its plans to adopt regulations clarifying that entity-level income taxes, even if elective, are generally “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 stated that taxpayers may rely on its provisions before the issuance of the proposed regulations.32 Proposed regulations have not yet been issued, and it is not clear how the Biden administration intends to proceed.33 The legal foundation and policy merits of the notice have been disputed.34

Notice 2020-75 prompted additional states to adopt entity-level business income taxes. A recent detailed analysis by Steven Wlodychak described the entity-level taxes, commonly referred to as passthrough entity (PTE) taxes, used by 25 states and the District of Columbia, most of which were enacted in the wake of the TCJA. In general, each state’s PTE tax applies to passthrough income allocated to the state, and resident owners may claim credit for their shares of the tax against their state individual income tax liabilities. Connecticut’s PTE tax is mandatory, while the others are elective. Wlodychak noted that the details of the PTE taxes vary greatly across states and that the variation creates complexity.35

Each state with a PTE tax generally provides that its residents may claim credit for their shares of any “similar” PTE taxes paid to other states by entities in which they hold ownership interests. However, Wlodychak and others have noted that residents may incur difficulty in claiming credit for PTE tax payments to other states.36 A recent Maine Board of Tax Appeals decision denied residents credit for PTE tax payments to Connecticut.37

While PTE taxes may not offer a perfect cost-free arbitrage opportunity, states have found them more appealing than payroll tax swaps.

III. Reform Options

A. Reforms in Simplified Framework

I begin by considering how reform might proceed in the context of the simplified framework considered in Section II.

In the simplified framework, the appropriate treatment is clear in two cases. No change is needed in the treatment of state sales and excise taxes and each business owner’s share of an entity-level business income tax payment should be treated as an individual income tax payment by the owner.

In the simplified framework, state employer payroll taxes could be addressed through an allocation method or a surrogate method. For any state business tax, the allocation method deems the tax to be paid by the parties to whom it is shifted rather than by the business. The surrogate method reduces the business’s above-the-line deduction to match the limited deductibility that would have applied if the state tax had been directly paid by the parties to whom it is shifted. The allocation method is conceptually appealing, but the surrogate method may be more politically palatable.

The allocation method allocates the state employer payroll tax to the employees who actually bear its burden and treats the tax as if it had been directly imposed on the employees. The employer’s $100 tax remittance is deemed to be a wage payment to the employees, the employees’ wages are grossed up by $100 for federal tax purposes, and the employees are deemed to pay the $100 tax. Employees for whom the capped itemized deduction is available may claim it for the deemed tax payment.

The allocation method treats the employer payroll tax identically to the employee payroll tax. The method doesn’t change the employer’s federal tax liability relative to today’s law because the employer claims an uncapped above-the-line deduction for the deemed wage payment in place of the similar deduction it now claims for the tax payment. The method leaves the employer’s deduction untouched because, as discussed above, that deduction doesn’t provide favorable tax treatment in isolation. Instead, the allocation method restricts the employees’ implicit automatic deduction, which is the underlying source of the favorable tax treatment.

The allocation of the tax and the gross-up of employees’ wages would impose some administrative costs. More important, the tax gross-up is likely to be politically unpalatable.

The surrogate method reduces the employer’s deduction for the tax payment without altering the federal tax treatment of the employees. The employer’s deduction for employer payroll taxes is limited to approximately match the limited deduction that employees can claim for employee payroll taxes. The employer is taxed as a surrogate for the employees. Imposing the deduction disallowance on the employer would be administratively easier and would probably arouse less political opposition.

At first glance, the surrogate method may seem unacceptable because the employer is overtaxed, and the employees are undertaxed. That tax mismatch is less of a problem than it seems, however, because the economic burden of the employer’s deduction disallowance is shifted to employees in the same manner as the payroll tax itself is shifted to them.

Of course, the surrogate method can, at best, achieve parity only in the aggregate, not for each employee. Suppose that under a state employee wage tax, 5 percent of the tax would have been paid by employees who itemize, aren’t subject to the AMT, don’t elect to deduct state sales taxes in lieu of state income taxes, and are below the TCJA cap. If those employees all have the same marginal tax rate as the employer, aggregate tax parity could be achieved by disallowing 95 percent of the business deduction. However, all employees — those who would have been able to claim the capped itemized deduction and those who would have been unable to do so — would effectively receive a deduction for 5 percent of their shares of the payroll tax burden.

Despite those difficulties, the federal income tax system uses surrogate taxes in several contexts. Section 162(m) disallows the deduction for some payments of executive compensation; section 274(n) partially disallows the deduction for business meals; section 280G disallows a deduction for excess golden parachute payments; and section 404(a)(5) disallows a deduction for an employer’s contribution to a nonqualified deferred compensation plan until the contribution is includable in the employee’s gross income. Those surrogate taxes have provoked little objection.

B. Beyond the Simplified Framework

The real world is considerably more complicated than the simplified framework. The distribution of the economic burden of sales and excise taxes, employer payroll taxes, and passthrough business income taxes probably don’t precisely match the assumptions made in that framework. Also, other state taxes pose more complicated issues than those three taxes.

The simplified framework assumed that state sales and excise taxes are shifted to buyers in the form of higher prices. That assumption has some economic foundation. The standard economic theory of border adjustments demonstrates that under specific auxiliary assumptions, the immediate permanent adoption of a uniform destination-based sales tax will cause the price level to immediately rise by a percentage equal to the sales tax rate, relative to the prices paid by residents of other states, with no change in residents’ incomes, relative to the incomes of residents of other states. However, those auxiliary assumptions are unlikely to hold. Moreover, even general sales taxes (let alone selective excise taxes) are not uniform across all consumer products. Nonuniform taxes have an array of complicated effects, altering relative prices of different products and the relative incomes of the workers and capital owners producing those products.

The simplified framework assumed that state employer payroll taxes are shifted to employees in the form of lower wages. However, the tax may not be fully shifted in the short run, as wage reductions may prompt employees to supply less labor and the resulting scarcity of labor blunts the wage reduction. Full shifting is more likely in the long run if the reduced labor supply is ultimately accompanied by a smaller capital stock.

The simplified framework assumed that state taxes on passthrough business income are borne by the owners. Even for a purely residence-based tax, that assumption might not hold if the tax reduces the nationwide volume of passthrough business activity. Moreover, because state business income taxes apply to nonresidents’ business income allocated to the state, the taxes may alter the location of passthrough business activity. A reduced volume of passthrough business activity in the state would likely lower wages in the state.

In general, however, those complications don’t alter the policy conclusions discussed above. Regardless of how the burden of each tax is distributed, it likely doesn’t change depending on the form that the tax takes. With minor exceptions, sales and excise taxes remitted by sellers impose the same burdens as those remitted directly by buyers, employer payroll taxes impose the same burdens as employee payroll taxes, and entity-level business income taxes impose the same burdens as owner-level business income taxes. The key policy goal should be to identify simple treatments that can be applied impartially within each pair of similar taxes, even if the treatments are imperfect. Errors should not be corrected for one tax if they are not also corrected for other similar taxes. The recommendations arising from the simplified framework offer a suitable set of simple treatments.

Suppose, for example, that economists definitively discovered that only 80 percent of the burden of state employer payroll taxes is shifted to employees, with employers bearing the other 20 percent of the burden. Then it would also be true that 20 percent of the burden of state employee wage taxes is shifted to employers in the form of higher wages, with employees bearing the other 80 percent of the burden. In the interests of simplicity, the federal tax system surely wouldn’t treat employers as paying 20 percent of state employee wage taxes. Instead, state employee wage taxes would still be treated as if their burden fell solely on employees, despite the discovery that the actual burden was distributed differently. To maintain parity of treatment, employer payroll taxes should then also be treated as if their burden fell solely on employees.

Similarly, because the federal tax treatment of state sales and use taxes remitted by buyers will surely be based on the assumption that their burden falls on buyers, the treatment of state sales and use taxes remitted by sellers should also be based on that assumption, even if it isn’t precisely correct. Because the treatment of state owner-level business income taxes will surely be based on the assumption that their burden falls on owners, the treatment of state entity-level business income taxes should also be based on that assumption, even if it isn’t precisely correct.

Bigger complications arise regarding taxes for which the distribution of the burden is unclear. For those taxes, neither the allocation method nor the surrogate method is easy to implement.

Consider the application of the allocation method to state corporate income taxes. If their burden falls on shareholders, the allocation method would deem the tax payment to be a dividend payment, which (unlike a deemed wage payment) wouldn’t be deductible. Shareholders’ incomes would be grossed up by the deemed dividend, and they would be deemed to pay the tax, for which they could claim the capped itemized deduction, if available. Or if the burden falls on employees in the form of lower wages, state corporate income taxes would be allocated to employees in the same manner as state employer payroll taxes. Neither a tax gross-up for shareholders nor one for employees seems politically viable. On the other hand, if the burden falls on customers in the form of higher prices (as may happen because of apportionment formulas that use a destination-based sales factor), state corporate income taxes would be treated in the same manner as state sales and excise taxes, and the uncapped above-the-line deduction would be retained.

The surrogate method doesn’t require any allocation or tax gross-up. At first glance it may seem that the method does not require the identification of the parties who bear the burden of the state tax. The surrogate tax imposed on the business will automatically be shifted to those parties, even if nobody ever learns who they are. However, the appropriate percentage disallowance of the business’s above-the-line deduction depends on the extent to which those parties would be unable to claim a deduction for a tax imposed directly on them. It is therefore necessary to identify those parties and determine how many of them claim the standard deduction, are subject to the AMT, or are above the TCJA cap.

In reality, none of the simple assumptions about the burden of state corporate income taxes can be fully correct. For one thing, state corporate income taxes must have some impact on noncorporate businesses and their customers and employees. The distribution of the burden of state property taxes is also difficult to determine.38

The best approach to state business taxes may be a broad application of the surrogate method, with varying percentages of the business deduction disallowed for different categories of business tax payments. The percentage disallowance would be based on an estimate of the extent to which the parties who are thought to bear the tax burden would have been unable to deduct the tax if it had been directly imposed on them. The definitions of the tax categories would pose challenges because states would have an incentive to relabel taxes in order to move them into categories different from their economic substance. Current law faces similar challenges in the classification of state and local taxes, as illustrated by the rules in section 164(b)(5)(B), (C), and (D) and reg. section 1.164-3(f) and (g) that distinguish general sales taxes from selective excise taxes.

IV. Conclusion

The deduction for state and local business taxes has received much less scrutiny than the deduction for state and local nonbusiness taxes. State and local business taxes often receive preferential federal tax treatment relative to other state and local taxes. Although reform may be difficult, there is a strong case for narrowing or eliminating the disparate federal tax treatment.

FOOTNOTES

1 This article doesn’t discuss the treatment of taxes paid to foreign governments or to Puerto Rico and the other overseas possessions.

2 Section 164(a) also provides that, except for income and property taxes, taxes connected to the acquisition of property must be capitalized as part of the acquisition cost and taxes connected to the disposition of property must be treated as a reduction in the amount realized from the disposition.

3 In 2026 an itemized deduction is slated to be restored for state and local taxes, other than income, property, and sales taxes, that are connected to the trade or business of providing services as an employee or to the production of non-rental, non-royalty income. The deduction will be a miscellaneous itemized deduction subject to the floor of 2 percent of adjusted gross income set forth in section 67(a) and disallowed under the AMT.

4 Kaplow, “Fiscal Federalism and the Deductibility of State and Local Taxes Under the Federal Income Tax,” 82 Va. L. Rev. 413, 461 (Apr. 1996).

5 OMB, “Analytical Perspectives, Budget of the U.S. Government, Fiscal Year 2022,” at 115, 118 (May 2021); JCT, “Estimates of Federal Tax Expenditures for Fiscal Years 2020-2024,” JCX-23-20, at 37, 41 (Nov. 2020).

6 CBO, “Options for Reducing the Deficit: 2021 to 2030,” at 62-63 (Dec. 2020).

7 President’s Advisory Panel on Federal Tax Reform, “Fair, Simple, and Pro-Growth: Proposals to Fix America’s Tax System,” at 130 (Nov. 2005).

8 Jeff Stein, “White House Advisers Privately Float Minimum Tax on Corporations Amid Blowback Over 2017 GOP Law,” The Washington Post, Feb. 19, 2020.

9 Knoll, “Disparate Treatment of Business and Personal SALT Payments,” Tax Notes, Jan. 15, 2018, p. 375.

10 Quoted by Jonathan Curry, “White House Adds Corporate AMT and SALT Cap to 2.0 Wish List,” Tax Notes Federal, Feb. 24, 2020, p. 1350.

11 Blanchard, “SALT Deduction Repeal Is Just Wrong,” Tax Notes, Jan. 8, 2018, p. 271.

12 Committee for a Responsible Federal Budget, “Five Ways to Improve the FY 2022 Reconciliation Package” (Sept. 21, 2021).

13 Buyers may be required to directly pay use tax to the state treasury when they make taxable purchases from sellers that aren’t required to collect sales tax. Section 164(b)(5)(E) provides that buyers who itemize and who elect to deduct sales taxes in lieu of income taxes may deduct use tax payments made as part of a general state sales tax but not payments made as part of a selective excise tax.

14 IRS, “2020 Instructions for Schedule C,” at 9 (Jan. 2021).

15 Id. at 8.

16 The offset may not always be exact because the increase in gross receipts may indirectly increase federal tax liability under section 41(c), 59A(e)(1)(B), 263A(i), or 448(c).

17 Section 164(b)(5)(G) provides that buyers may claim the itemized deduction for state general sales taxes (but not selective excise taxes) that are legally imposed on the seller if the buyers pay the tax to the seller as a separately stated amount.

18 Because the state’s residents have the same nominal taxable incomes as before, they pay the same nominal taxes to the federal treasury as before. Because the federal treasury’s purchases are not subject to the state sales tax, the federal treasury’s purchasing power is unchanged.

19 Knoll, supra note 9, at 378.

20 Kaplow, supra note 4, at 465.

21 The IRS instructs taxpayers that deductible state income taxes include mandatory contributions to the California, New Jersey, and New York nonoccupational disability benefit funds; the Rhode Island temporary disability benefit fund; the Washington supplemental workmen’s compensation fund; the Alaska, California, New Jersey, and Pennsylvania state unemployment funds; and the New Jersey and California state family leave programs. IRS, “2020 Instructions for Schedule A,” at 3, 4 (Jan. 2021).

22 Hemel, “The Death and Life of the State and Local Tax Deduction,” 72 Tax L. Rev. 151 (2018-2019).

23 Suzanne Woolley, “State Tax Workarounds Could Mean $154 Billion Lost to Treasury,” Bloomberg, Jan. 25, 2018.

24 For prior coverage, see Peter L. Faber, “New York’s New Payroll Tax: A Work-Around for SALT Deduction Limits?State Tax Notes, June 25, 2018, p. 1279.

25 Jimmy Vielkind, “More New York Businesses Using State Law to Avoid SALT Tax Cap,” The Wall Street Journal, Dec. 20, 2019.

26 T.D. 8189. The regulation is grandfathered from section 7805(e)(2)’s three-year limit on the duration of temporary regulations.

27 Reg. section 1.62-1(d) was included in the income tax regulations reprinted in 25 F.R. 11201 (Nov. 26, 1960). In Cutler v. Commissioner, T.C. Memo. 2015-73, the Tax Court stated that the regulation was adopted in 1945 and reviewed prior cases applying the regulation.

28 Those reports were cited in JCT, “General Explanation of Public Law 115-97,” JCS-1-18, at 67 n.289 (Dec. 2018).

29 Knoll, supra note 9, at 379.

30 H.R. Rep. No. 115-466, at 260 n.172 (Dec. 15, 2017).

31 JCT, supra note 28, at 68 n. 296.

32 For prior coverage and analysis, see Emily L. Foster, “Partnership, S Corp SALT Payments Not Subject to Deduction Cap,” Tax Notes Federal, Nov. 16, 2020, p. 1143; and Timothy P. Noonan and Joseph R. Rekrut, “IRS Blesses SALT Cap Workaround: What’s Next in 2021?Tax Notes State, Dec. 21, 2020, p. 1323.

33 Amy Hamilton, “State Variations on SALT Cap Workaround Are a Potential IRS Issue,” Tax Notes State, Oct. 4, 2021, p. 94.

34 For criticisms of Notice 2020-75, see Monte A. Jackel, “SALT Workaround Notice Works Politically but Not Legally,” Tax Notes Federal, Nov. 16, 2020, p. 1131; Michael L. Schler, “Still More on Tax Regulations and the Rule of Law,” Tax Notes Federal, Dec. 7, 2020, p. 1633; and Anonymous, “The Unequal Benefits and Tax Disparity of Notice 2020-75,” Tax Notes Federal, Dec. 21, 2020, p. 2012. For a defense of Notice 2020-75, see Thomas J. Nichols, “SALT Parity Workaround Really Does Work,” Tax Notes Federal, Nov. 30, 2020, p. 1491.

35 Wlodychak, “They’re All Different and That’s the Problem: State PTEs,” Tax Notes State, Aug. 2, 2021, p. 455.

36 Id. at 461-462; Walter Hellerstein and Andrew Appleby, “State Tax Credit Issues Raised by SALT Cap Workaround Legislation,” Tax Notes State, Jan. 18, 2021, p. 211; Hamilton, “Advisers Push for State Guidance on SALT Cap Workaround,” Tax Notes State, Oct. 4, 2021, p. 96.

37 Wlodychak, “I Told You So: Maine Denies Resident Credit for Other State’s PTE Tax,” Tax Notes State, Nov. 8, 2021, p. 613.

38 For analysis of the property tax deduction under simplifying assumptions about the distribution of its burden, see Kaplow, supra note 4, at 461-464, and Knoll, supra note 9, at 376-378. For a classic discussion of the possible distribution of the property tax burden, see Henry Aaron, “A ‘New’ View of Property Tax Incidence,” 64 Am. Econ. Rev. 212 (May 1974).

END FOOTNOTES

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