The $10,000 SALT cap enacted as part of the Tax Cuts and Jobs Act of 2017 has policy flaws. I have written about this a few times in recent years (7/4/19, 9/21/18) and in a few AICPA comment letters I signed as chair of the Tax Executive Committee (such as 11/10/17). The policy flaws include:

1. Why are C corps the only business entity allowed to fully deduct their state and local business taxes? State and local taxes are a normal expense of any business so should be deductible in computing taxable income. The reason non-C corp businesses (and their individual owners) are subject to the SALT cap even on state and local income taxes on business income is a 1944 law that made such taxes deductions from AGI rather than for AGI and Congress didn’t fix that in 2017 when it added the SALT cap. This should be fixed.

2. There are good arguments to be made that all taxes should be deductible from income as they are mandatory payments. But, here, I think a limit makes sense. The TRA’86 removed the deduction for sales tax although the original proposal was to remove the personal deduction for all state and local taxes, because sales tax ties to personal consumption. There is a lot of logic to that. That same logic applies to personal and real property taxes too. If someone wants to own 10 homes, why should everyone else subsidize the property taxes on it? I posit that the Schedule A deduction for property taxes should be limited to what they would be on a 1400 square foot home at the median price in that region.

So, we start with flaws in just having a $10,000 cap.

The policy flaws were made worse with Notice 2020-75* that allows even elective taxes that a state imposes on a partnership, S corp or LLC to be treated as an entity tax for federal purposes despite most states that have recently enacted these taxes treating the taxes as a tax credit for owners.  Basically, the entity is paying the state income tax on behalf of the owners with that tax moving from Schedule A to Schedule E where there is no SALT cap. This works for partners and S corp shareholders in states that have enacted these taxes. It does nothing for individuals hitting the SALT cap due to wages, investment income, sole proprietor income and real property taxes on their home.

   [*Yes, it was good that Treasury and IRS tried to fix a flawed law to start with.]

I don’t disagree with the Notice 2020-75 statement that a tax imposed directly on a passthrough entity (PTE) and not separately stated for the owner is an entity tax, just the reason why we should have a workaround for elective taxes and just for passthroughs. Of the roughly 20 states that have enacted these entity income taxes, it is only a mandatory tax in Connecticut.

The elective PTE regime in about 19 states has led to a lot of compliance challenges because the PTE taxes are different among the states as to how to elect and pay, whether any owners can opt out or are not eligible, what income is covered, whether the tax applies against the owner’s state tentative minimum tax, the rate, and more.

And these challenges can also raise issues on how they interact with other income tax rules. For example, California’s PTE (added by AB 150), is elective. The entity can’t elect though until it timely files its return. However, the entity can pay the tax before then using Form 3893 which the FTB recently released. Also, owners (if qualified) must consent to the tax, and the entity just pays the 9.3% tax on the income of the consenting owners (that is an odd entity level tax!).

I think the payment form was released early so owners could get the federal tax benefit of the PTE tax on their 2021 return (the tax isn’t due until 3/15/22 for a calendar year entity). BUT what about accounting method rules and the definition of a deposit? If the PTE tax is paid by 12/31/21 but the entity doesn’t make the optional election, then the tax is refunded. This means that any payment before the election is really a “deposit” and “deposits” are not deductible.

A payment is a deposit under the USSC Indianapolis Power & Light case if the payor is not fully on the hook to take the action related to the payment (such as buy power) and has “complete dominion of control” over the funds. Since the entity can get the tax payment back until the time when it makes the irrevocable election, it doesn’t look like the entity can deduct the PTE tax paid in 2021 on its 2021 federal 1065 or 1120S, meaning it won’t be on the federal K-1 for 2021.  It would still be a 2021 item for California purposes, but the federal benefit would not occur until 2022 when the election is made.

Beyond the deposit issue, an accrual method entity has an issue with the all events test of §451 in that there is a contingency that the tax isn’t really owed by the entity until the election is made and that can’t be made until 2022. I don’t think a signed statement from all consenting owners helps because the entity could still not elect or not get it timely made.

Now, we don’t yet have any regs from the IRS that were promised but I doubt the IRS would write them contrary to the law on deposits and the all events test of §451, but you never know. Perhaps for states with a PTE tax regime like California’s they would allow payment to be treated as enough to make the entity liable in the year paid.

What a lot of complexity and confusion when considering tax policy and the proper treatment of state and local taxes for individuals years ago could have resolved the issues of the proper treatment of state and local taxes on Form 1040 (the issue was raised before TRA’86 – see page 62 of 1984 Blueprints for Tax Reform Vol 2). Hopefully someday we’ll see that policy discussion and an improved federal tax treatment of SALT.


What do you think?