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November 10, 2020

Treasury to Approve Pass-Through SALT Cap Workarounds

Tax Scheme

State and local taxes imposed at the entity level on pass-through entities are permitted as a deduction and this "is consistent with the long-standing position" of the U.S. Department of the Treasury and the Internal Revenue Service, the agencies said Monday.

In a notice with an accompanying news release from Treasury Secretary Steven T. Mnuchin, the agencies said they intend to promulgate regulations that will clear up the long-standing question of whether it is OK for states to tax pass-throughs at the entity level, knowing that this can be a workaround to the $10,000 state and local tax deduction cap imposed by the Tax Cuts and Jobs Act  .

The agencies said upcoming regulations will "clarify that state and local income taxes imposed on and paid by a pass-through entity are allowed as a deduction by the pass-through entity in computing its non-separately stated taxable income or loss for the taxable year of payment."

Moreover, the agencies said pass-throughs can rely on the upcoming proposed regulations starting Monday. Pass-throughs can apply the upcoming rules to certain income taxes paid beginning with the 2018 tax year and before the date the proposed regulations are published in the Federal Register.

"The Department of the Treasury and IRS are taking the necessary steps to provide fairness for America's small businesses," Mnuchin said. "These proposed regulations will offer clarity for individual owners of pass-through entities."

For more than a year, Treasury and the IRS had a lot to say about other efforts to give residents and businesses a workaround to the state and local tax deduction cap imposed by the TCJA, releasing frequent and detailed guidance on a number of other workaround techniques. As recently as August, final rules allowed businesses to deduct contributions to a charitable entity as a trade or business expense rather than as a charitable contribution.

But on the creation of entity-level taxes on pass-throughs — a way for limited liability company members, S corporation shareholders and partners in partnerships to avoid the cap — the IRS and Treasury remained silent, leaving tax professionals to question whether these taxes would be respected as a matter of policy.

In the interim, however, states continued to adopt these entity-level taxes.

So far, seven states have adopted an entity-level tax on pass-throughs in which the state tax paid generates a federal deduction at the entity level and, in some states, a state tax credit at the partner level. Other states do not offer the credit, but the partners can exclude that portion of income that was subject to the entity tax.

On Monday, the agencies seemed to indicate that whether to grant a credit was up to the states, but the entity-level tax will be fine as a federal deduction.

"The Treasury Department and the IRS are aware that there is uncertainty" about the pass-through taxes, the agencies said in their notice. "The Treasury Department and the IRS intend to issue proposed regulations to provide certainty to individual owners of partnerships and S corporations in calculating their SALT deduction limitations."

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