The SALT Cap and the Marriage Penalty
The 2017 Tax Cuts and Jobs Act (TCJA) represented a step backwards in the effort to mitigate the marriage penalty. Although the standard deduction for married couples filing jointly (MFJ) is twice the standard deduction of single taxpayers, the TJCA limited the itemized deduction for state and local taxes (SALT) to $10,000 for both single taxpayers and those filing married jointly. State and local taxes include income and general sales taxes, real estate taxes, and personal property taxes. A married couple can exceed this threshold with state income taxes alone, resulting in the loss of any income taxes in excess of $10,000 and all real estate and property taxes. Although the MFJ standard deduction remained twice that of single taxpayers under the TCJA, the same SALT deduction limitation made it more difficult for those filing jointly to itemize deductions.
The three other main categories of itemized deductions, other than SALT, include medical expenses, mortgage interest, and charitable contributions. Only medical expenses in excess of 7.5% of adjusted gross income (AGI) are deductible. Due to the large amount of medical expenses needed to exceed this threshold, few taxpayers qualify; when they do exceed the threshold, it usually results in only a small deduction. Therefore, for married taxpayers to benefit from electing to itemize deductions, they must have an additional $15,900 ($25,900–$10,000) in deductible expenses other than taxes compared to an additional $2,950 ($12,950–$10,000) for a single taxpayer. If married taxpayers do not have sufficient medical expenses and mortgage interest, they will need charitable contributions to make up the difference in order to itemize deductions. Recognizing this conundrum, and not wanting to contribute a substantially greater sum to charities than they did before the TCJA, many married taxpayers succumb and claim the standard deduction. For married couples filing jointly, this results in failing to receive any tax benefit from charitable contributions.
By choosing not to itemize, married taxpayers could be “penalized” when filing their state and local income tax returns. In many state and local jurisdictions, in order to itemize on one’s state income tax returns, one must have itemized deductions on their federal return and not claim the standard deduction. Most states have a significantly lower standard deduction with respect to what taxpayers can claim as itemized deductions, even after adding back their deduction for state and local income taxes. As a result, the marriage penalty at the federal level flows down to the state and local level, resulting in a marriage penalty there as well.
In the authors’ opinion, the SALT limit of $10,000 for married taxpayers is more unfair in light of MFJ returns where both spouses have income subject to state and local income taxes as two-earner married couples. Even though some states offer a small reduction in taxable income for all two-income couples who file jointly in consideration of the marriage penalty, it is not substantial in mitigating the impact.
Although the TCJA included some tax provisions that reduced the married tax penalty (as stated above), the $10,000 SALT limit disproportionately increases taxes on married taxpayers filing jointly due to the limit being the same for every filing status. In the spirit of mitigating the marriage penalty, the authors believe that Congress should consider raising the SALT limitation for married taxpayers filing jointly to make it more equitable.
SALT Cap Workarounds and Entity Choice
The SALT cap can also result in unfair treatment of trade or business income due to a taxpayer’s choice in the form of entity to transact their business activity (i.e., pass-through entity versus C corporation). A C corporation receives an unlimited deduction for state and local income taxes. Pass-through entities including S corporations, partnerships, and sole proprietorships, by virtue of the fact that there is no income tax at the entity level, do not receive this benefit. That same income flows through to the individual returns of the business owners, where it is subject to state and local income taxes and becomes subject to the SALT cap.
In November 2020, the Department of the Treasury and the IRS released Notice 2020-75 announcing the intent “to issue proposed regulations to clarify that State and local income taxes imposed on and paid by a partnership or an S corporation on its income are allowed as a deduction by the partnership or S corporation in computing its non-separately stated taxable income or loss for the taxable year of payment.” Notice 2020-75 further states: “In enacting section 164(b)(6), Congress provided that ‘taxes imposed at the entity level, such as a business tax imposed on pass-through entities, that are reflected in a partner’s or S corporation shareholder’s distributive or pro rata share of income or loss on a Schedule K-1 (or similar form), will continue to reduce such partner’s or shareholder’s distributive or pro rata share of income as under present law. H.R. Rep. No. 115-466, at 260 n. 172 (2017).’” Based upon this language, certain states have enacted, or are in the process of enacting, legislation that would impose an entity-level tax on pass-through entities that would serve to reduce the non-separately stated taxable income or loss for the year of payment. For state income tax purposes, the state tax paid by the entity, which reduces non-separately stated taxable income or loss, must be added back for state and local income tax purposes on the individual owner’s income tax return.
As of March 1, 2023, 30 states and New York City have enacted entity-level tax elections to work around the federal cap on this individual SALT deduction limitation. In these states, pass-through entities (partnerships and S corporations) may elect to pay the state income tax on behalf of its owners on the pass-through entity’s non-separately stated taxable income. The individual owners’ non-separately stated income is reduced by the state income tax payment made by the electing pass-through entity, and the owners are entitled to a credit against their state income tax liability equal to the amount of the payment. In effect, the entity-level election attempts to alleviate the impact of the SALT limitation as it applies to pass-through entity income to individual owners. In most of the states that have passed such legislation, the entity-level tax is elective.
The SALT cap causes residents of states that have state and local income taxes, in addition to property and real estate taxes, to have greater amounts of state and local taxes that are not deductible.
Making this election is important for multi-state pass-through entity business owners. To avoid double taxation, states only offer credits for taxes paid to other states based on income. These entity-level taxes may not be eligible for a particular state’s income tax credit. In addition, if the election is made to pay the entity-level tax, one or more business owners who do not reside in that state may have little or no income tax liability in that state to offset with the credit, consequently resulting in double taxation. It is important to understand the nexus issues as they apply to the non-separately stated taxable income of the pass-through entity for each state in which the entity transacts business.
These provisions, however, complicate state tax return compliance: “Entity-level taxes cannot approximate individual income tax codes very effectively, as they are designed for different purposes and with different structures” (Jared Walczak, “IRS Signals Approval of Entity-Level SALT Cap Workaround, But States Still Think Twice,” Tax Foundation, Nov. 11, 2020). Furthermore, such provisions do not address the unfairness of the same business income attributed to a sole proprietor. The IRS’s SALT workaround relief only applies to partnerships and S corporations; sole proprietors do not qualify. Taxpayers conducting business as a sole proprietor may want to consider establishing a pass-through entity for this purpose.
Recently, legislation has been proposed in Congress that would raise or repeal the SALT cap. The main objection to proposed legislation has been that raising the cap would benefit mainly higher-income taxpayers. If Congress would allow state and local income taxes attributable to all business income (including sole proprietor-ships) from pass-through entities to be deducted without limit—not state and local income taxes on other income—there would be greater equity across the forms of doing business. Furthermore, this would represent a compromise overcoming, to some degree, the high income–taxpayer objection. State and local income taxes on other income would still be subject to the SALT cap. The pass-through entity tax elections vary from state to state. Several states, including Hawaii, Iowa, Kentucky, Vermont and West Virginia, also have pending legislation; therefore, careful consideration should be given to the effect of elections on taxpayers.
Deductibility and Residency
A final inequity resulting from the SALT cap involves the state and local tax structure of the taxpayer’s state of residency. The $10,000 SALT deduction cap is quickly reached by taxpayers who reside in high-tax states. In addition, some states generate a greater proportion of their revenues from real estate, personal property, and sales taxes; and less or none from income taxes. The SALT cap causes residents of states that have state and local income taxes, in addition to property and real estate taxes, to have greater amounts of state and local taxes that are not deductible. Currently, nine states do not impose an income tax. Residents of states that impose little (or no) income tax may deduct more of their other state and local taxes (real estate and property taxes).
The current SALT cap results in tax “penalties” for married couples, sole proprietors, and residents of high-tax states. If Congress were to address these three areas and reach a compromise on these controversial issues between representatives from high- and low-tax states, the result could be greater equity among taxpayers and the basis of marital status, form of business, and residency.