Clarity at Last – IRS Indicates Forthcoming Approval of SALT Cap Pass-Through Entity Workarounds

On November 9, 2020, the IRS issued Notice 2020-75 (the “Notice”) informing taxpayers that forthcoming proposed regulations would clarify that state and local income taxes imposed on and paid by a partnership or S corporation (a “pass-through entity” or “PTE”) on its income are allowed as a deduction by the PTE in computing its non-separately stated taxable income or loss for the year of the payment, meaning that such payments are not taken into account in applying the State and local tax (“SALT”) cap limitation to any individual who is a partner of shareholder in the PTE.

Background

Those familiar with this blog will be aware of the uncertainty surrounding the so-called SALT cap “PTE workarounds” that states (including Connecticut and New Jersey) have enacted to combat the federal legislation capping the individual state and local tax deduction at $10,000 per year beginning January 1, 2018.  For a brief refresher, please see prior posts here and here.  The theory behind these workarounds is that, because the SALT cap applies only to individuals, state and local income taxes applied at the entity level should be fully deductible at the Federal level without regard to the individual limitation.  Before the Notice, many practitioners wondered whether the IRS and Treasury would attempt to prevent the PTE workarounds, especially given their extended silence on the viability of these attempts by states to circumvent the SALT cap.

The Notice

After a brief summary of the relevant authority and background, the Notice provides that Treasury and the IRS intend to issue proposed regulations permitting PTEs to deduct “Specified Income Tax Payments” when computing their non-separately stated income or loss.  The Notice defines Specified Income Tax Payments to mean “any amount paid by a [PTE] to a State, a political subdivision of a State, or the District of Columbia [Domestic Jurisdictions – U.S. territories are not included] to satisfy its liability for income taxes imposed by the Domestic Jurisdiction on the [PTE].”  This is true regardless of whether the imposition of and liability for the tax paid by the PTE is the result of an election by the entity.  Similarly, it is immaterial whether the partners of shareholders of the PTE received a partial or full deduction, exclusion, credit, or other tax benefit based on their share of the amount paid by the PTE.  Where a Specified Income Tax Payment is made, the PTE is entitled to a deduction for that payment when computing its taxable income for the year the payment is made.

Finally, and most importantly, the Notice provides that “[a]ny Specified Income Tax Payment made by [PTE] is not taken into account in applying the SALT deduction limitation to any individual who is a partner in the partnership or a shareholder of the S corporation.”  This effectively blesses PTE workarounds, and provides “certainty to individual owners of PTEs [and their advisors] in calculating their SALT deduction limitations.”

The forthcoming proposed regulations described by the Notice will apply to Specified Income Tax Payments made on or after November 9, 2020, but the Notice also indicates that the proposed regulations will permit PTEs to apply these rules to Specified Income Tax Payments made in a taxable year of a PTE ending after Dec. 31, 2017, and before November 9, 2020 (provided that the Specified Income Tax Payment is made to satisfy the liability for income tax imposed on the PTE pursuant to a law enacted prior to November 9, 2020).

Conclusion

Despite the good news, there are continuing questions surrounding just how much benefit the Notice will provide given that President-elect Joe Biden has discussed replacing the $10,000 SALT cap with a 28 percent limit on all itemized deductions for those earning more than $400,000, which could eliminate the usefulness of PTE workarounds.  Although the current SALT cap’s future remains uncertain, the Notice still represents a huge victory for PTEs in the here and now.  While many practitioners and state officials were optimistic about the viability of PTE workarounds, the certainty provided by the Notice is a welcome clarification. 

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