The same week our Parity for Main Street Employers group released its model pass-through SALT reform bill, critics of state SALT fixes fired a couple salvos that are worth noting.  First, the IRS announced it plans a new rule putting the kibosh on the SALT charitable “workaround” being considered by several states.

IRS Notice 2018-54 has no direct impact on the S-Corp’s proposed pass-through SALT fix.  Legal scholars can debate the validity of the charitable workaround (a couple recent papers that do a surprisingly good job of that, here and here), but the pass-through fix recently proposed by New York does not depend on swapping a tax for a charitable contribution.  Instead, it would shift the incidence of the tax from the owner (where it is not deductible under the tax overhaul) to the business (where it is).  It’s still a tax – it’s just being paid by a different taxpayer.

That’s the key element that was missed in the second salvo, an article from the Tax Foundation arguing that New York’s proposed pass-through fix is poorly thought out and unlikely to work.  Here’s how they describe the plan:

Under current law, pass-through businesses (S corporations, partnerships, LLCs, and sole proprietorships) are not subject to an entity-level tax, unlike C corporations, which pay corporate income taxes. Instead, their income passes through to owners, who report it on their individual income tax forms (ownership-level taxes).  In order to extend a SALT deduction cap avoidance option to pass-through business owners in the event that the charitable contribution recharacterization scheme fails, New York officials propose to change all that.  (Emphasis added.)

Describing the proposal as an effort “to extend a SALT deduction cap avoidance option” allows the Tax Foundation to avoid stating clearly what New York is doing – restoring the SALT deduction for pass-through businesses.  This reform has nothing to do with the charitable fix.  It has everything to do with leveling the playing field with C corporations, who continue to fully deduct their state and local income taxes under the tax overhaul.

There are other flaws to the Tax Foundation’s analysis:

  • They assert that “unincorporated businesses don’t pay entity-level taxes almost by definition.” Not true – pass-throughs pay many entity level taxes (sales, property, and income) and those taxes remain deductible to the business. Tennessee, for example, imposes a 6.5 percent entity-level income tax on pass-through businesses, and those taxes are deductible under the new law.
  • The Tax Foundation argues that the New York proposal would result in higher state taxes for business owners. Not true.  The approach outlined by New York is to collect the same amount of revenue from the business while protecting the owner from double taxation.  There should be no net tax increase.  The reason credits passed on to the owners are less than 100 percent of the entity-level tax paid is to reflect the lower, after-tax income allocated to them by the business.
  • The Foundation references some tweets from Professor Hemel of the University of Chicago arguing taxing the income at the entity will not restore the SALT deduction because the full amount of income will still show up on the owner’s K-1. We disagree.  Entity level state taxes are deducted in determining the ordinary taxable income on the federal K-1.  An S corporation in Tennessee already pays entity level income taxes and those taxes reduce the income that shows up on its owner’s Federal K-1.  It’s the reduction of K-1 income that makes the entity level tax “deductible.”

The Tax Foundation raises legitimate concerns about the proposal, including a possible-negative effect on out-of-state owners.  This challenge is real and can be divided into three camps of owners – those that live in states with no income taxes, those that live in states like Colorado that already recognize the credits included in the New York plan, and those that live in states with income taxes that don’t recognize the credits.  Taxpayers in the first two camps should benefit; those in the last camp are in danger of double taxation.  The new law adopted by Connecticut addresses this issue by recognizing out-of-state credits allocated to Connecticut business owners.  Other states will need to follow suit to protect their taxpayers.

They also raise concerns about complexity.  How complex the plan is really depends on the organization and ownership of the business.  For an S corporation operating in the same state where the owners reside, there’s no complexity, it’s straightforward.  For a partnership with multiple layers of ownership and owners spread out in multiple states, it could get very complex.  An entire industry of SALT accountants exists to do nothing but calculate the state and local tax liabilities of pass-through businesses.

One reason our model legislation makes this reform an election is to address these concerns.  Businesses with out-of-state owners and/or complex ownership structures can simply opt out of the entity level tax and sidestep these issues.  As part of our comments to New York, we intend to press that point.

The Tax Foundation concludes that the “proposal is, in short, a mess.”  Wrong again.  It’s the new pass-through rules on SALT that are a mess, not our response to it.  Why are corporations allowed to deduct state taxes levied on their income, but not S corporations?  No policy explanation was articulated during the tax overhaul debate, largely because there is no good explanation.  Business expenses are business expenses, regardless of the business’ form.  You won’t find a justification for the disparity in the Tax Foundation paper either.  They simply ignore it.  Yet this lack of parity and fairness is at the base of our SALT reform efforts.  It’s the 800-pound gorilla that the Tax Foundation ignores.