It’s been seven years since the first state enacted our SALT Parity legislation restoring the SALT deduction for pass-through businesses.
Since that time, thirty-five other states have followed suit, the IRS issued Notice 2020-75 in support of the state laws, and Congress considered but rejected several efforts to repeal or otherwise limit the deduction for pass-throughs. (As always, C corporations continue to deduct their SALT without limitation or debate.)
After all that, you’d think the tax community would accept that our SALT Parity laws are in good standing. You’d be wrong.
The latest example of hand-wringing comes from a recent Tax Notes article, where the authors make the following observation:
Congress or the IRS might clarify the deductibility of PTETs in the coming months or years. Until then, taxpayers and their advisers will need to take into account both the absence of any follow-up to Notice 2020-75 and the statutes and regulations that cast doubt on whether PTET payments may be deducted from non-separately-stated taxable income. [Emphasis added.]
The casual reader might come away thinking there’s still some ambiguity to the issue – there isn’t. State and local taxes directly paid by pass-through businesses have always been deductible and continue to be deductible under the new rules. Here’s the lead paragraph from Treasury Notice 2020-75:
This notice announces that the Department of the Treasury (Treasury Department) and the Internal Revenue Service (IRS) intend to issue proposed regulations to clarify that State and local income taxes imposed on and paid by a partnership or an S corporation on its income are allowed as a deduction by the partnership or S corporation in computing its non-separately stated taxable income or loss for the taxable year of payment.
The notice goes on to point out:
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.” H.R. Rep. No. 115-466, at 260 n. 172 (2017).
The conclusions of the Notice are consistent with the legal analysis S-Corp sponsored regarding our SALT Parity legislation enacted in Wisconsin in 2019:
The Internal Revenue 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.
For the IRS to reverse itself, it would have to ignore the very clear statement of legislative intent included in the Conference Report of the TCJA:
In describing the conference agreement with respect to the final section 164(b)(6) provision contained in the Tax Cuts and Jobs Act, the Conference Committee Report states as follows: “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.”
Such legislative history is quite compelling. As the Supreme Court noted in United States v. Vogel Fertilizer, “Of course, it is Congress’ understanding of what it was enacting that ultimately controls.” Vogel, 455 U.S. 16, 31 (1982). In that case, the Supreme Court held that “The legislative history of [one of the provisions contained in the controlled group provisions of the Code] resolves any ambiguity in the statutory language and makes it plain that [an inconsistent provision in the Treasury regulations] is not a reasonable statutory interpretation.”
It would also have to reverse numerous established revenue rulings on the treatment of SALT paid by pass-through entities:
For example, in Revenue Ruling 58-25, the Service ruled that a City of Cincinnati tax on net profits “imposed upon and paid by a partnership” is “deductible in computing the taxable income of the partnership.” Similarly, in Revenue Ruling 71-278, the Service ruled that an Indiana tax imposed on gross income at the partnership level (thereby exempting such gross income from tax at the individual partner level) is deductible from partnership gross income “in computing the taxable income of a partnership and the distributable shares of the partners.” The Service has consistently followed these rulings in its publications. For example, publication 535, “Business Expenses,” “For use in preparing 2018 returns,” states that “A corporation or partnership can deduct state and local income taxes imposed on the corporation or partnership as business expenses.”
And:
The Service followed these prior rulings to reach the same conclusion with respect to another Wisconsin tax based on income in a Field Service Advisory, which dealt with the Temporary Recycling Surcharge imposed under section 77.92 of the Wisconsin Statutes. At the time, the Surcharge was imposed at the rate of .4345% on the net business income of S corporations and partnerships allocated or apportioned to Wisconsin (subject to a cap of $9,800 and other exceptions). Citing both Revenue Ruling 58-25 and Revenue Ruling 71-278 and analyzing the provisions in the Code and Regulations requiring the separate treatment of certain items passed through to partners, the Service concluded that “the Wisconsin temporary surcharge . . . imposed on and paid by a partnership based on its net business income . . . is not separately stated under section 702(a)(1) through (7) of the Code and . . . would be included under section 702(a)(8) in determining the partnership’s [nonseparately computed] taxable income or loss,” unless section 469 (relating to passive activity losses) applied.
Another issue is that our SALT Parity laws allow the taxpayer to elect to pay at the entity level, as if the presence of an election makes the tax voluntary or illegitimate. Once again, these arguments ignore the long history of other elections in the Tax Code and their historic treatment.
There are numerous elections under state and federal law, and the results of those elections have been consistently respected under the Code. Perhaps most fundamentally, revocation of an S corporation election itself and check-the-box elections for partnerships and limited liability companies to be treated as corporations (without making a corresponding S corporation election) trigger state-level corporate income and other taxes in nearly all circumstances.
As noted, taxes triggered at the entity level by such elections are deductible, the same as the entity-level taxes of C corporations. The same applies to our SALT Parity elections.
Finally, missing from the SALT Parity critiques is a discussion of the other taxes paid by pass-through entities that are non-separately stated and deductible at the federal level:
For example, the District of Columbia has imposed an income tax on corporations, including S corporations, and an unincorporated business franchise tax on partnerships at the entity level since at least 1975. Just like under Wisconsin Act 368, the corresponding income is excluded from taxation at the individual shareholder or partner level.
Also similar to Wisconsin, Pennsylvania allows S corporations to opt out of pass-through treatment for its state income tax. Conversely, Georgia, Mississippi, New Jersey and New York require some form of affirmative election or consent to qualify for S corporation pass-through treatment. Finally, Alabama, California, Illinois, Kentucky, New Hampshire, New York City and Tennessee have also had income taxes imposed at the entity level for some time.
All of these entity-level income taxes have been consistently deducted in calculating nonseparately computed income passed through to the owners for federal income tax purposes, and have not been treated as state income taxes paid at the individual level so as to trigger disallowance of the standard deduction, alternative minimum tax disallowance and/or the Pease reduction.
The DC approach to taxing S corporations was the basis for our SALT Parity model legislation. Those taxes have been applied since the 1970s and have always been deducted in computing nonseparately stated income.
The bottom line is our SALT Parity laws are well grounded in all legal respects – with the statute and IRS rulings and case history. Arguing otherwise would require a complete rewrite of the rules regarding how businesses treat the taxes they pay to states and localities. It would also be contrary to the legislative record, and Treasury and the IRS have made clear they have no intention or incentive to do so.
Nonetheless, the debate continues, at least among some inside the beltway. One sure way to clear this up would be for Treasury to issue final regulatory guidance consistent with Notice 2020-75. S-Corp will work to get that done in the coming months. In the meantime, businesses and practitioners should make their SALT Parity elections with confidence. Reversing the fundamental principles the government and practitioners have been relying on since enactment, principles based on decades of published guidance and legislative history, is just not a realistic possibility.