Prior to the Tax Cuts and Jobs Act (TCJA) in 2017, individuals were able to claim a deduction on their federal income tax returns for state and local taxes paid; the TCJA added a $10,000 limit to those deductions. This affected a lot of taxpayers, particularly wealthy individuals and those in high tax states like California and New York. There has been debate at the federal level at 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.
States have pursued a number of workarounds, but the most popular was blessed by the IRS in November of 2020 – pass-through entity taxes. 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 entity would pay tax at the entity level which would get around the federal limit of $10,000 on individuals. The individual taxpayer would then get an offsetting credit for their state return allowing them to avoid double-taxation and to get the full benefit of their state taxes paid.
Currently 20 states have enacted this legislation, three states have legislation pending, and more 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 taxpayers and a huge change in the way flow-through entities are taxed. We say “potential” because federal action could remove the limit and make almost all of this moot. The news on federal action changes every week and the states have all enacted rules to accomplish the same goal, but with wildly varying methods. Compliance is going to be complicated, but the potential benefit makes this something taxpayers will need to look into.