The Tax Cuts and Jobs Act (TCJA) passed in 2017 included limits in the amounts of state and local taxes individuals are now able to deduct. States have tried to work around these limits in a number of ways, but the most popular that has been blessed by the IRS can help business owners lower their tax bills.
Prior to the TCJA, individuals were able to claim a deduction on their federal income tax returns for state and local taxes paid; the legislation placed a $10,000 limit on those deductions. This affected taxpayers, particularly business owners, wealthy individuals and those in high tax states like California and New York. There has been debate at the federal level about removing the limit, but the politics are tricky. The states most affected are Democrat controlled, but removing the deduction limit would mostly benefit wealthy taxpayers.
Enter pass-through entity taxes, the solution used by most states that was blessed by the IRS in November 2020. Pass-through entities, such as partnerships, LLCs and S corporations, are not typically subject to income taxes but pass their income to their owners, who then pay tax on that income. With pass-through entity taxes, the business elects to pay tax at the entity level, which would get around the federal deduction limit of $10,000 for individuals. The individual taxpayer would then get an offsetting credit for their state return, allowing them to avoid double-taxation while getting the full benefit of their state taxes paid.
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The details of each program vary by state, as do income tax rates, but I can briefly explain how the savings are calculated. The business pays the state tax (not federal tax) on its income and still passes that income on to the owner to report. The state then offers the owner a credit or some other way to offset the tax paid at the entity level, so the taxes paid to the state at the combined business and individual level are unchanged. The state tax expense paid by the business reduces the income passed on to the owner and the amounts that they report and pay on their federal return. The state tax expense has remained the same but the federal income tax has been lowered — a real savings to the business owners!
More than 20 states have enacted legislation enabling this solution. Several others have such legislation pending, and more still are expected to join if action is not taken at the federal level. This has the potential to be a big tax savings opportunity for business owners and a huge change in the way pass-through entities are taxed. I say “potential” because federal action could remove the deduction limit and make almost all of this moot.
The news on federal action changes every week, and many states have enacted rules to adapt, all with their own rules. With each state having their own systems of pass-through entity rules and often the need for filing additional returns, compliance is going to be complicated. Despite the possibility for additional complexity, the potential benefit makes this something business owners and managers will need to look into. If you haven’t already, this is a great time to reach out to a tax professional for more information.
