The House Select Revenue Subcommittee held a hearing today entitled “How Recent Limitations to the SALT Deduction Harm Communities, Schools, First Responders, and Housing Values.” Missing from the list are Main Street Employers, many of whom lost the ability to deduct the State and local taxes they pay on their business income.

That’s because tax reform subjected deductions on state and local taxes (SALT) paid by pass-through business owners to the same $10,000 cap as taxes paid on wages and property.  Taxes paid by the business entities themselves, like C corporations, remain fully deductible.

Since most states tax pass-through businesses at the owner level, this policy increases Main Street Employer tax rates and puts them at a competitive disadvantage compared to C corporations.  It also puts these businesses at a disadvantage compared to those operating in states that have no income tax, like Texas and Florida.

This is a BIG deal!  The S Corporation Association estimates that 3.6 million (out of 4.8 million S corporations nationally) will lose their SALT deduction this year, the equivalent of paying an extra 2 percentage points of tax on average.  Millions more partnerships face the same tax hike.

In response to this new policy, the S Corporation Association and the Parity for Main Street Employers coalition has been working with states to restore the SALT deduction at the state level by allowing pass-through businesses the option of paying their SALT at the entity level.  To date, four state legislatures have adopted this reform – Connecticut, Wisconsin, Oklahoma, and Louisiana.

One outstanding concern for businesses is how the IRS will respond.  We fully expect Treasury to weigh in on this issue at some point, but it’s unclear what such guidance would entail.  As our legal analysis points out:

The Internal Revenue Service (the “Service”) 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, such as the standard deduction, alternative minimum tax and the Pease reduction. In discussing the final provisions of the Tax Cuts and Jobs Act, the Conference Committee Report explicitly reiterated and relied upon this principle in describing the scope of new section 164(b)(6) of the Code.

It was widely expected Treasury would make some sort of pronouncement on the pass-through SALT front when they issued final rules to kill the so-called charitable workaround earlier this month, but they did not.  The longer they wait – Connecticut passed their reform over a year ago, after all – the better it looks for restoring pass-through SALT deductions.  A recent article from Law 360 appears to agree:

After digesting it, some tax professionals speculated that not only did it provide protection for C corporations, but it also outlined a way for other business owners, particularly sole proprietors, partners or sole owners of LLCs, to get around the proposed SALT cap rules — an option not available to individuals who don’t own businesses. By ignoring various state entity level tax schemes, the final regulations leave the door open for those business owners to do so.

And indeed, some states have taken steps to allow resident business owners to bypass the SALT deduction cap, and others have considered doing so. States such as Connecticut, Wisconsin, Oklahoma and Louisiana have enacted legislation to allow pass-through entities to elect taxation at the entity level. The federal taxation agencies have thus far turned a blind eye to schemes protecting pass-through entities while lowering the boom on those that might benefit individuals who do not own businesses.

So, continued progress on restoring SALT deductions for pass-through businesses.  Congress may ignore the challenge of pass-through parity, but the states aren’t.