Last month, the Bipartisan Policy Center put forward some suggestions on how to address the pending sunset of the State and Local Tax (SALT) cap, including rolling back the pass-through “SALT Parity” laws we helped enact in 36 states. A couple of thoughts.
Pass-Through Parity
First, the SALT cap played a big role in our efforts to ensure pass-through businesses were treated fairly under the TCJA. The SALT cap raises huge amounts of revenue ($100 billion-plus per year) and about 20-30 percent of that is paid on pass-through income. For comparison, that’s about half the total revenue impact of the 199A deduction, so the loss of SALT deductions significantly undercut any 199A benefit.
For reasons unknown, the TCJA did not extend the SALT cap to so-called “C SALT” — state income taxes paid by C corporations. Those taxes remain fully deductible.
This imbalance – C corporations deduct their SALT, S corporations subject to the cap — exacerbated the rate disparity already imbedded in the TCJA. As we wrote at the time:
[The Senate bill] ignores the effects of repealing the SALT income tax deduction for S corporations while preserving it for C corporations. Preventing businesses from deducting this business expense could raise marginal rates on S corporations significantly, depending on which state they reside in. Those in Wyoming, for example, would see no effect, while those doing business in California would see their marginal rates increased by five-percentage points. On average, SALT repeal raises effective marginal rates by between two- and three-percentage points.
The initial Senate draft called for a top corporate rate of 20 percent, whereas the top pass-through rate was 38.5 percent. Add in the NIIT and the disparate SALT treatment, and the top pass-through rate was around 45 percent. Even companies that received the new 199A deduction paid close to 40 percent – or about twice the corporate rate. (For those worried about the double corporate tax, we addressed that here.)
During Senate consideration, S-Corp and its allies worked to 1) lower the top individual rate and 2) increase and broaden the 199A deduction, resulting in more equitable treatment. We were unable, however, to get the bill’s sponsors to budge on the SALT disparity.
So our Main Street Employer coalition worked with the states to allow S corporations and other pass-throughs to elect to pay their SALT at the entity level, thus restoring their SALT deduction by affording them the same treatment that C corporations receive. Thirty-six states (out of forty-one where they would be applicable) have adopted these laws. (What is your damage, Pennsylvania?)
Which brings us to our first quibble with the BPC write-up. Here’s what they say:
Since the SALT cap was enacted in 2017, pass-through business owners have taken advantage of state government level workarounds to deduct more than the allowed $10,000 in SALT from their federal taxes. Thirty-five states allow pass-throughs to pay SALT at the entity level, meaning individual owners avoid the $10,000 SALT deduction cap. This violates the spirit of TCJA’s SALT cap. Closing state workarounds for pass-through entities would ensure that pass-throughs are subject to the same caps as individuals.
Au contraire. The SALT Parity bills don’t violate the “spirit” or any other aspect of the law. The difference is they can now elect to have their SALT paid by the entity and deductible as a business expense – just like C corporations. Here’s the operative argument in the legal analysis we did for Treasury:
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,1 the Conference Committee Report explicitly reiterated and relied upon this principle in describing the scope of new section 164(b)(6) of the Code.
The TCJA’s SALT policy was not that pass-throughs don’t get their deduction anymore, but that SALT paid by individuals would now subject to the cap. SALT paid by pass-throughs directly would still be deducted as business expenses. The Treasury Department agreed with our analysis in Revenue Ruling 2020-75, stating:
In enacting section 164(b)(6), Congress provided that “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.”
Long story short, our SALT Parity laws are consistent with the spirit, the letter, and every other aspect of the TCJA.
The Corporate SALT Loophole
Our second quibble with the BPC recommendation is they separate the question of SALT deductions for pass-throughs and C corporations. Their write-up argues:
Closing SALT workarounds for pass-through businesses without addressing C-SALT could lead to more inequitable tax treatment. To address this imbalance, policymakers could eliminate deductibility for SALT on corporate income taxes while continuing to allow corporate deductions for wage, sales, and property taxes paid.
Well amen for somebody recognizing that allowing C SALT deductions while capping everybody else is patently inconsistent. Why should the SALT cap apply to the local hardware store but not Home Depot?
Beyond that, the BPC comes close to the truth but doesn’t quite grasp it. The only reason our SALT Parity reforms work is because C corporations still deduct all their SALT. If Congress were to cap C SALT deductions, they would also cap the deductions of pass-throughs, even for those taxes paid at the entity level.
It’s a C corporation loophole, not a pass-through loophole.
Conclusion
So if the new Congress wants to stop disadvantaging Main Street, it can take one of two approaches. Either keep the status quo where individuals are subject to the SALT cap but businesses – all businesses – are not, or extend the SALT cap to include all taxpayers, including C corporations.
We prefer the first approach as it promises lower taxes for all businesses. If Congress chooses the second approach, on the other hand, it would raise enormous amounts of revenue, all of which should be used to offset the cost to making the 199A deduction permanent. It’s only fair.