The SALT deduction has been a longstanding benefit for taxpayers who pay state and local taxes. However, recent limitations to the SALT deduction have left taxpayers in high-tax states looking for alternatives. One such option is the PTE tax election, which allows pass-through entities to pay and deduct state and local taxes on behalf of their owners.
The SALT deduction, also known as the State and Local Tax deduction, is a provision of the U.S. federal tax code that allows taxpayers to deduct certain taxes paid to state and local governments from their federal taxable income. These taxes can include state and local income taxes, sales taxes, and property taxes. The SALT deduction is intended to alleviate the burden of double taxation on taxpayers subject to federal and state/local taxes.
The SALT deduction has been a part of the tax code since its inception in 1913. Initially, taxpayers could deduct all state and local taxes from their federal taxable income. In 1964, Congress began to restrict the SALT deduction to only include state and local income taxes. This restriction was loosened in subsequent years to include sales and property taxes as well.
Before the Tax Cuts and Jobs Act (TCJA) in 2017, there was no limit to the amount of SALT an individual taxpayer could deduct on their federal income tax return. However, the TCJA limited the SALT deduction to a maximum of $10,000 (for married couples filing jointly). This limitation is set to expire in 2025.
Impact on taxpayers
The limitation of the SALT deduction has significantly impacted taxpayers in high-tax states. Taxpayers who previously relied on the SALT deduction to reduce their federal taxable income were faced with higher tax bills under the TCJA. In some cases, this has led taxpayers to consider changing their residency to a state with a lower income tax rate to mitigate the impact of the SALT deduction limitation.
Pass-through entity (PTE) owners have been particularly impacted by the change to the SALT deduction. Corporations are not subject to the same SALT limitation as individual taxpayers, which has created an uneven playing field between PTE owners and corporations.
PTE tax election
After the TCJA was enacted, many states, especially those with high tax rates, began formulating workarounds to provide relief to taxpayers. One such workaround gained traction.
In November 2020, the IRS issued Notice 2020-75 indicating that SALT paid for by a partnership or S corporation on behalf of the partners or shareholders could be deducted in computing the partnership’s federal taxable income that flows through to the partners. Essentially, this provides a workaround for the SALT deduction limitation by allowing the PTE to pay for and deduct SALT before income is passed to the individual owners. With this information, many states began designing the requirements and procedures for their pass-through entity tax election.
Most states (29, as of January 2023) have enacted a version of the PTE election to provide relief from the SALT limitation and encourage individuals and businesses to continue operations in their jurisdictions. PTE election rules and procedures vary from state to state, and some are more complex than others. While most states have enacted a PTE level tax, several still have proposed legislation pending or no proposed legislation. For this reason, it’s important to consult with your tax advisor to determine what is available for your specific situation.
This article is intended to provide a brief overview of the SALT deduction and PTE tax elections. It is not a substitute for speaking with one of our expert advisors. For more information, please contact our office.