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Interview: Recapping States’ SALT Cap Workarounds

Posted on Sep. 9, 2021

Nikki E. Dobay, a partner with Eversheds Sutherland (US) LLP’s tax practice group, discusses the SALT cap workarounds for passthrough entities that many states have adopted and possible coming developments for those policies.

This transcript has been edited for length and clarity.

David D. Stewart: Welcome to the podcast. I'm David Stewart, editor in chief of Tax Notes Today International. This week: SALT substitutes.

As states have begun wrapping up their 2021 legislative sessions, a new trend in state tax policy has emerged: a rise in passthrough workarounds to the state and local tax deduction cap. The $10,000 limit on the SALT deduction has been a major source of contention since it was enacted as part of the Tax Cuts and Jobs Act in 2017. Higher tax states, like New York and California, have viewed it as a threat to their tax regimes and led others to explore legislative workarounds to the federal policy.

How are states approaching these workarounds? Are they the most effective way to deal with the SALT cap?

Here to talk more about this is Tax Notes senior reporter Paul Jones. Paul, welcome back to the podcast.

Paul Jones: Thanks, Dave. Good to be back.

David D. Stewart: Now, Republicans enacted the SALT deduction cap as part of the TCJA and some Democrats have been quite vocal about wanting to repeal it. Could you give listeners some background on the politics behind the policy?

Paul Jones: Sure. Republicans in Congress backed the policy to help pay for the new tax law. Part of the debate ever since has been whether capping the SALT deduction was a swipe at high-tax, progressive states, often blue states, where taxpayers may have relied upon the deduction to help offset the high-state tax burden. Progressive Democratic politicians have accused Republicans in Congress and the Trump administration of sort of seeking to undermine their tax structures.

David D. Stewart: Why are these states going toward these workarounds now?

Paul Jones: In fact, both blue and red states have been approving these workarounds, even though there's been a lot of talk about these being targeted at blue states. There's about 19 states that have adopted them total and about 12 of those have been in 2021.

The workaround essentially applies to taxpayers that receive passthrough income. The state creates a tax that the passthrough entity pays, in most cases via an election, on its income. The state then gives the owners a tax break, usually a credit, to offset that tax on their passthrough income.

The effect is that the entity is paying the state income tax for its owners. It can take a full federal deduction for that state tax, unlike the owners who are limited by the cap, and the benefit of that full deduction is received by the owners. This is seen by states as a way of helping those taxpayers, offsetting the cost of their taxes at the expense of the federal government, and ensuring that they are a more competitive or attractive business environment.

David D. Stewart: Now, I understand you recently spoke with someone about this topic. Could you tell us about your guest and what you talked about?

Paul Jones: I spoke with Nikki Dobay who's a partner with Eversheds Sutherland. She talked about the adoption of this workaround by states, and she also delved a bit into the different rules that states have adopted for their particular version of this type of workaround.

She also got in some other issues, including whether Congress might actually repeal the SALT cap before its scheduled expiration, which obviously would impact whether these policies are going to be particularly impactful, and a lot of other issues that I think listeners will find interesting.

David D. Stewart: All right, let's go to that interview.

Paul Jones: Nikki, thanks for joining us today.

Nikki E. Dobay: Thank you so much, Paul.

Paul Jones: Let's get into some of the issues. After the TCJA passed, we saw a couple of different kinds of proposals for how states could try and help taxpayers sort of work around the $10,000 SALT deduction limit.

There was one that was popular for a little while that had to do with providing taxpayers with credits for donations that they made to state-supported causes. But the IRS put the kibosh on that and said that it would not allow that to work.

Then we saw more states begin adopting these so-called passthrough-entity-type workarounds. The popularity of that particular model of workaround has surged since the IRS and Treasury said in a notice in November that they will allow that type of workaround wherein the passthrough entity pays the tax and is able to take a full deduction because the SALT cap applies to the individual taxpayer and not the entity.

You've got a whole bunch of states that have said, "Well, this sounds great. Let's follow the lead of some of the early adopters. We'll adopt this as well." 

But as we've discussed before, it's not the case that this particular type of workaround, as adopted by each state, is identical. All of these states have a little bit of a variation between their model. Can you talk to some of the differences that we're looking at here between states' passthrough entity workarounds?

Nikki E. Dobay: Sure, Paul. It wouldn't be a state tax discussion without us talking about how the states all like to be different. I will attribute this to Bruce Ely. When we were working on the RAR/Partnership Project with the Multistate Tax Commission, he described the states' approaches to the RAR provisions as each state was like a snowflake, uniquely different. I think that really applies here as well.

I think Connecticut was the first state that adopted this, and their model was a mandatory model. It's the only state that has required passthrough entities to use this workaround. It's basically a mandatory tax, but they also provide a corresponding credit.

The rest of the 18 states that we've seen adopt SALT cap workarounds have gone with an elective model. It might sound like, "OK, we've got one and then we've got 18 other ones." But it wouldn't be that easy of a conversation if that were the case either.

I really divide these into two big issues: who can elect into these SALT cap workarounds and how they work.

Let's start with the "who." There's a variety of different ways in which the states are doing this, with respect to who can elect in. Some states have rules on what types of passthrough entities can elect in.

In Oregon, for example, only passthrough entities that have individual owners or a single passthrough layer with individual owners can elect in. Other states will allow a passthrough entity with any passthrough owner, so it could be a corporation or another passthrough entity with other corporate owners. The states definitely vary there.

Then you have to look at some of the specific rules about how a passthrough entity might elect in. I think this still falls into the "who" category, because there are certain states where you have to get all of the partners in alignment on this. I think there's definitely a group of folks that become owners in passthroughs or partners in partnerships because they don't like to be told what to do. Getting all those folks to march in one common direction I think will definitely have its challenges.

We've seen the states put in some very strict restrictions as to what specific types of entities and then what will need to happen for an entity to elect in. I think that's one level of how different these really are.

Then, when we move to the "how," it's how does this SALT cap workaround work so that it effectuates what we're trying to get to? And that is to lower the overall federal tax burden by applying the tax at the entity level, but then also making the partner whole at the state level.

We see one variety and one path the states have gone down where the income attributable to that partner where the partnership has paid tax will be excluded from that partner's state income. We see an exclusion methodology. Then we see several states, and I think this is probably the majority role, that provide a credit. They're going to get a state-level credit for the state tax that was paid at the entity level.

Here again, we don't see everybody perfectly falling in line. We see some states giving a dollar-for-dollar credit, and then we see other states providing a haircut.

This is all before we really get to how the information gets put on the form. What are the mechanics of the election going to be? How is this going to be reported to the partners? We don't have uniform rules with respect to state-level K-1s. There are going to be a lot of challenges there that I think practitioners will be working through for quite a while.

Paul Jones: It sounds like for entities taking advantage of this, there's going to be some complexity. There isn't going to be one approach that everyone can use.

But as we've also discussed, there's also some implications that could complicate the use of these workarounds if you are an entity that is operating in multiple states. If you're a passthrough entity that just operates within one state, then you've only got to worry about that one state's rules.

But can you talk about what one of the problems might be for an entity that's operating in multiple states, that has partners in multiple states or operations in other states, that is paying one of these entity-level taxes or possibly multiple entity-level taxes as part of multiple workarounds in other states? What is one of the major problems there?

Nikki E. Dobay: As we've seen, the proliferation of partnerships generally is an entity that's doing business on a multistate basis. That wasn't always the case. Often it was corporations that were operating on more of a multistate basis. I don't think that's any longer the case.

We have a lot of partnerships that are doing business on a multistate basis. Layer on top of that COVID-19 and the remote work environment, you now have partners in these entities that may no longer be residing in the state. You may have a single-state partnership, but the partners have now moved. A lot of complexity has been overlaid on this already complex issue.

I think one of the challenges and probably the biggest minefields as partnerships try to figure out whether or not they will elect into these SALT cap workaround regimes is thinking about where the partners in that partnership are residents. Will the resident state that the partners reside in recognize the credit or the exclusion from income in that situation?

That's where there's a lot of uncertainty. There's a few states, Virginia and Washington, D.C., come to mind, where there was clear guidance prior to these SALT cap workarounds that disallowed an individual resident partner to take a credit for any taxes paid at the entity level. Why would we have cared about that pre-SALT cap workaround? Well, we had states imposing tax on partnerships or an entity-level tax.

We've got some guidance out there related to a totally different issue that seems to be prohibitive for purposes of what's going on here. We also saw New York include very specific language that a credit would only be provided if there's some substantially similar language. What does that mean?

I think we're going to see a lot of states grapple with will they be respecting a credit that an individual resident taxpayer is trying to claim for tax paid at the entity level in another state? I don't think we have a clear answer on that. It will definitely be an area to watch.

That's the simple version if you've got a partnership operating in one state, they make the election and you've got a resident in just one other state. What if you've got partners in 20 different states? You've got to make the determination as to what is the impact to the partners for purposes of making the election.

But then also will they get to claim that credit and see the benefit in their resident state? As you can imagine in the multistate environment, there's going to be a lot of questions there.

Paul Jones: As we know, the SALT cap has been controversial. Progressive Democrats have savaged it as an attack on blue states, which often have more progressive tax structures, in an attempt to pay for more services.

After the TCJA was approved, a lot of people were complaining that this was potentially going to undermine or threaten those states' tax models. We've seen a lot of talk recently, now that the Democratic Party controls Congress and the White House, that there may be an effort to repeal the SALT cap before it expires at the end of 2025.

In your opinion, is there a likelihood that would happen? Are these SALT cap workarounds a day late, a dollar short in the sense that just as states are adopting them, they may be about to be kaput? Or is it likely that the cost of repealing the cap is going to be an obstacle that those who would want to see it repealed are going to be unable to overcome?

Nikki E. Dobay: I think the more interesting question in some ways is because the SALT cap is meant to expire, are these a day late and a dollar short for that reason? I think that was some of the thought at the beginning. But now there are all these discussions about the SALT cap being repealed. I'm not holding my breath.

There's been a lot of discussions about tweaking the SALT cap. I think we've heard of increasing it from $10,00 to $15,000, and then also doubling that for joint filers, and providing some relief in that way. But to the point you made, this was one of the biggest base broadeners when the TCJA was adopted.

What do I mean by that? Under the TCJA we saw a significant rate decreases on the corporate side. We saw some rate decreases on the individual side as well. In order to make up for those, there were all these base broadeners that were adopted as well to increase the base so we could lower rate. This was a significant one. I want to say it was in the trillion dollar area. It's a really, really hard hole to plug.

Now, what I think is going to be fascinating to watch is do these SALT cap workarounds negate that base broadener? Make it at the end of the day maybe the feds should just bring it back because we're all going through this big process and they're not getting the base they wanted because the states have found a workaround, which the IRS has blessed. Or maybe we see the IRS retract from their guidance.

I think this is definitely an area to watch. I think the states will continue down this path, as long as it looks like the cap is going to remain.

Paul Jones: In your opinion, no one should be waiting for the federal government necessarily to repeal this. It's more a question, at this point, as to whether these workarounds are successful enough to counteract the SALT cap in a broad sense, generally.

Nikki E. Dobay: I feel like this is one of those slippery slope moments. We've already started down this path. It's going to be very hard for the federal government to retreat 100 percent and go back to the way life used to be. My sense is we're going to get to some middle ground eventually. What specifically that looks like, I don't think we know yet.

Paul Jones: One of the things you mentioned is that the federal government may have to take a look at this and see if these workarounds are really becoming an existential threat to the policy. I should note, as you've previously mentioned in our conversations, that the Treasury and the IRS both put out this guidance in November saying, "This workaround will be recognized, will work, will be honored."

But it is now August of 2021 and we still do not have any guidance. We had all these states passing their version of this type of a workaround to the SALT cap, but we don't really know yet what the actual final rules for it are going to look like.

What do you think the tax professionals and taxpayers are going to need to see from the federal government? What are they looking for? What risks are there, if any, to the policy, the use of these workarounds, that exists until we have some kind of really solid guidance from the federal government about how it's going to work, and what they are and potentially are not going to allow within the context of this?

Nikki E. Dobay: Interestingly, everybody's gotten pretty darn comfortable with this, just based on that IRS notice that came out last year. What did we see? I think it was about 10 states, maybe more, that all passed the SALT cap workarounds this year.

When you read that guidance, it doesn't get in the weeds too much. It really just blesses this concept of yes, the entity paying the tax falls outside of the cap as adopted by the TCJA. The IRS does say they will provide additional guidance, but to your point, we haven't seen it.

I don't know at this point how high on the IRS's list of to-dos this is. It doesn't seem like they're overly concerned with this issue. I don't know if maybe they thought the states wouldn't move forward all that quickly, or this wouldn't be that big of an issue, but it would be nice to see some guidance.

It would be nice to see what specifically will partnership have to do on the forms to make sure this is all copacetic. But I just don't think we know that. Right now everybody's operating under the assumption that we're all good. I think the IRS can't provide guidance on how these credits and these exclusions at the state level will work. I see some risks that partnerships, practitioners, and partners are going to have to deal with, get comfortable with, because we don't know what's exactly going to happen on that state side.

I think at the end of the day, those credits could be a big deal, too. I don't have anything great on what the IRS will do. Hopefully we get something and it will provide the detail so that everybody is comfortable. That for federal purposes, we can carry on under this methodology.

But until we see some cases, or there's challenges where states have denied credits, or you don't get the exclusion in a different state than where you paid the tax, the IRS can't bless that. That's going to be questions that get dealt with on an individual state basis by state tax courts. We'll see what happens there.

Paul Jones: If we assume that the SALT cap isn't repealed, that the IRS, Treasury, or Congress doesn't decide to say, "Hey, these workarounds are negating this policy. We're going to try and disallow them." When it comes time for the SALT cap to sunset, maybe the concern about the revenue hits is such that it gets extended, assuming the SALT cap workarounds are not so undermining the policy that it's no longer serving its original intended purpose.

If this is something that maybe is a longer-term issue, or even for the period of years these things apply, if there's enough potential interest at stake, is there any potential for states to modify these, to try and amend them, to make them a little bit more consistent with one another?

Nikki E. Dobay: Uniformity would be great if the SALT cap workaround is here to stay. I don't think it's going away anytime soon. I think we're going to see evolution in this space. I think we're going to see more states adopt these indefinitely the next few years.

It's a little bit reminiscent of marketplace and remote seller collection laws. The states went full bore. We didn't quite get that uniformity we were hoping for. I think we're in a little bit of a different situation here.

The MTC just kicked off a couple of weeks ago a massive project looking at many different issues related to partnership taxation in the state tax space. This is an issue that they've got on their list of things they will be talking about as part of that project. That project is so massive. I worry a little bit this particular issue might get lost in the weeds. I think it's one that is particularly relevant right now.

Maybe that's incumbent upon the business community to really use their voices and say, "Hey, we know we really need the MTC. We need the states. We need everybody to come together and think about this issue." It would be wonderful if we could see a model. It would be wonderful if we could at least get comfortable that the states that don't have SALT cap workarounds will nonetheless recognize the credit or the exclusion provided by a state that does have a SALT cap workaround.

I think getting some clarity on some of those issues would be really helpful. To the extent the MTC could help facilitate that, I think it would be great. But I think there continues to be some evolution.

I think on the practitioner side, we're all still wrapping our heads around these different pieces of legislation, trying to figure out which one we like the best. Once I think the practitioners can figure that out, then we can come forward and say, "Hey, look at this state. I think they did it really, really well." I think that's still a little bit of a work in progress. This probably shouldn't have caught us by surprise, but in some level I think the amount of bills that passed this year got everybody's attention. It's like, "OK, now we've really got to dig in and figure all this out. Because it's probably not going away."

Paul Jones: It's definitely been a huge surge since that November guidance came out. We've been discussing this, for obvious reasons, in the context of the SALT cap workarounds as they're intended to function and the thing that they're intended to accomplish. But I think now that I'd be remiss if I didn't also bring up another point.

Leaving the SALT cap aside, is there some potential for these workarounds, now that they have established, for a very specific reason and under very specific sort of unusual rules, attacks on passthrough entity, as opposed to the members, that this could be turned by at least some states into a different policy long-term? That you could take that entity level tax and start using it for something other than just circumventing the TCJA limitation on the SALT deduction?

Nikki E. Dobay: I think that's the definite fear that has been on the minds of some of us in the policy space. I think that's also why there wasn't probably a land swell or whatever that phrase is of the business community behind this. I think there was the fear that, "OK, this is a new tax on passthrough entities, and we've really got to trust the state that they're going to give that credit or that exclusion."

By way of example, that was a very significant concern here in Oregon when they were passing their SALT cap workaround because credits have to come up for a mandatory review every six years. The fear really was what happens if the credit doesn't get renewed? I got pretty comfortable with the proposal because the passthrough entity-level tax in Oregon is elective.

Right now, as I mentioned earlier, all but Connecticut are elective. It's really the partnerships that will have to evaluate whether or not they want to elect into this regime. I'm going to be a glass half full person right now and say if the credit goes away, then they're not going to take away the election.

This is one of those odd code provisions that will have somebody scratching their head in 50 years, trying to figure out what the heck was all this about. But if the credits or the exclusions go away, and we see the states start taking away the election, then we are in a much different situation.

Paul Jones: I guess everyone is just going to have to keep watching this to see how it develops based on all of the unknowns. We started off the year with only a handful of states with these workarounds and now we're closing on half.

Do you think that these are the bulk of the states that are going to want to implement this policy? Or do you think that potentially even more are going to be adopting this, possibly even retroactively for the next year?

Nikki E. Dobay: Great question. I suspect there's going to be some more states that jump on board. I don't know that any state's going to go retroactively, unless one particular state model jumps out as like everybody just loves it and then it's like, why wouldn't you do it?

But I think we're going to continue to see the states move in this direction, especially if there's absolutely zero movement on the SALT cap workaround. Or if we really see the feds double down and make the SALT cap permanent.

I definitely think that this isn't the end of the story when it comes to states adopting these. There's some interesting bedfellows on this policy as well. But I think we'll see more of these in the future.

I think we'll see tweaks to them. I really just do hope they're tweaks in the direction to make these easier for partnerships to comply with and to take advantage of if the goal is to achieve those policy goals that everybody thinks we're trying to achieve.

Paul Jones: Nikki, thank you so much for spending time with us and sharing your insights on this issue. It's always a pleasure to speak with you.

Nikki E. Dobay: Thank you so much, Paul. Happy to be here.

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