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Editorial 11 MIN READ

The SALT cap at ten months: state workarounds that Treasury hasn't killed yet

Connecticut wrote the first pass-through entity tax in May, Wisconsin followed in September, and the charitable-fund route is already being shut down

The Editors
Staff, Incorporator.org
11 min read Updated
Contents 7 sections
  1. What §11042 actually did
  2. The charitable fund route, and why it is already dying
  3. The pass-through entity tax, Connecticut first
  4. Why Treasury has not (yet) moved on PTETs
  5. What a pass-through owner should watch
  6. The shape of 2019
  7. Sources

he $10,000 SALT deduction cap at IRC §164(b)(6), added by §11042 of the Tax Cuts and Jobs Act, is now ten months into a ten-year run, and the state reaction has sorted into two buckets. One bucket, the charitable fund route, is being dismantled in real time by proposed Treasury regulations. The other bucket, the pass-through entity tax, has been enacted in Connecticut and Wisconsin and is drawing quiet interest from at least a dozen state capitals, with no adverse federal guidance yet.

The cap itself was the single most politically contested individual provision in TCJA. It is not the provision tax practitioners spend the most time on, but it is the one state legislatures have spent the most time on.

What §11042 actually did

TCJA §11042 rewrote IRC §164 to add subsection (b)(6), limiting the itemized deduction for state and local taxes to $10,000 per return ($5,000 for married-filing-separately) for taxable years beginning after December 31, 2017, and before January 1, 2026. The cap aggregates the three deductible state and local tax categories: real property taxes, personal property taxes, and the greater of income or general sales taxes. It does not apply to taxes paid in carrying on a trade or business or in activity described in §212, which is the doorway every state workaround walks through.

The eight-year sunset matters operationally. Unless Congress extends it, the cap disappears for the 2026 tax year, along with most of the individual TCJA changes. State legislation written in 2018 therefore has to price in the possibility that the problem it solves will solve itself on January 1, 2026. Every state bill drafted this year that creates administrative machinery for a cap workaround has to be cheap enough to tear down in 2025 without leaving a crater, which shapes some of the drafting choices below.

The political geography is well known. The ten states with the highest per-return SALT deductions under pre-TCJA law were concentrated in the Northeast and on the West Coast, along with Illinois. Those are the states with the loudest workaround debates. A couple of lower-tax states have quietly watched and moved first anyway, because the pass-through entity tax route turns out to have modest appeal even where the cap is not binding on many residents.

The charitable fund route, and why it is already dying

New York moved first in April 2018, with Part LL of the state budget (A.9509-C / S.7509-C) creating a state charitable gifts trust fund and an education-related charitable fund. Contributions to either fund would generate a credit against New York state income tax equal to 85 percent of the contribution. The theory was pre-TCJA, straightforward, and dozens of states had run a variant of it for private school choice programs and historic preservation without federal objection: a state allows a dollar-for-dollar (or near dollar-for-dollar) credit against state tax for a contribution to an approved fund, and the taxpayer takes a charitable deduction federally. Post-cap, a deductible charitable contribution at full value in exchange for a state tax credit looked like a clean answer to the $10,000 ceiling.

New Jersey (S.1893, signed May 2018) authorized municipalities to do the same thing at the property tax level. Connecticut authorized a municipal variant in the same May 2018 bill that created its PTET. Oregon, New Jersey, and California all saw proposed legislation.

Treasury swung on May 23, 2018. IRS Notice 2018-54 signaled that the agency would issue proposed regulations "addressing the federal income tax treatment of certain payments made by taxpayers for which taxpayers receive a credit against their state and local taxes," and warned that substance-over-form doctrine, not the literal language of §170, would govern whether those payments were deductible. The notice did not cite statutory authority to disallow the deduction outright, but it signaled the posture.

The proposed regulations followed on August 23, 2018, as REG-112176-18, published in the Federal Register on August 27. The mechanic is narrow and brutal. A taxpayer who receives or expects to receive a state or local tax credit in return for a contribution must reduce the federal charitable deduction by the amount of the credit. There is a de minimis exception for credits that do not exceed 15 percent of the contribution, which covers most pre-existing state charitable credit programs for things like private school scholarships at lower credit percentages. It does not come close to covering an 85-percent credit program, or a 90-percent or 95-percent program of the kind other states drafted.

The comment period on REG-112176-18 closed October 11, 2018. The proposed regulations apply to contributions after August 27, 2018, the date they were published in the Federal Register, which means New York's trust funds effectively stopped functioning as a SALT cap escape the day the regulations dropped. A contribution made in July 2018 might still survive, depending on how Treasury finalizes the regs and what transition rules emerge. A contribution made in October 2018 does not.

Four state attorneys general sued in July 2018 (New York, Connecticut, Maryland, and New Jersey), State of New York v. Mnuchin, 1:18-cv-06427 (S.D.N.Y.), arguing the cap itself violates the Sixteenth Amendment and principles of federalism. The complaint is a political document with a long road in front of it. It does not offer a near-term fix for the 2018 return.

The pass-through entity tax, Connecticut first

Connecticut Senate Bill 11, signed May 31, 2018, by Governor Malloy, created the country's first true pass-through entity tax. The structure is a mandatory entity-level income tax at a flat 6.99 percent on the Connecticut-sourced distributive share income of any partnership, S corporation, or LLC treated as a partnership or S corporation for federal purposes. The entity-level tax is deductible by the entity as an ordinary state tax paid in carrying on a trade or business, which puts it outside the individual SALT cap entirely. Individual members then receive a credit against their Connecticut personal income tax equal to 93.01 percent of their proportionate share of the entity-level tax paid.

The math is engineered to be close to revenue-neutral at the state level for a Connecticut resident who was already paying Connecticut income tax on the same pass-through income. The 93.01 percent credit percentage is set so that the individual's final Connecticut tax liability is roughly what it would have been without the PTET, while the federal deduction for the tax moves from the individual (where it is capped at $10,000) to the entity (where it is not). For nonresidents with Connecticut-source income, the mechanic is slightly different because a Connecticut credit does not flow against another state's income tax. The net federal benefit depends on the resident state's rules on out-of-state tax credits.

Connecticut's PTET is mandatory, not elective, which distinguishes it from the later Wisconsin model. The mandatory structure removes any argument that the tax is merely a dressed-up version of the individual liability, because the entity has no choice and is directly assessed. It also removes planning flexibility. A Connecticut pass-through owner whose personal SALT position does not benefit from the workaround (low state income tax, property tax already above $10,000, other state deductions consumed) pays the PTET anyway and takes the state credit regardless of whether the federal math works in their favor.

Wisconsin enacted its version through 2017 Wisconsin Act 368, signed by Governor Walker in September 2018. The Wisconsin PTET is elective, made annually on a timely filed return, and applies at 7.9 percent to tax-option corporations (S corporations) under §71.365(4m)(a) Wis. Stat., with parallel treatment for partnerships. The elective structure is closer to the model drafters expect most subsequent states to adopt, because mandatory taxation without an opt-out creates real problems for the subset of owners who are worse off under the workaround than without it.

Minnesota, Oklahoma, Louisiana, and Rhode Island have seen public drafts. New Jersey, New York, California, and Illinois are all known to be studying the mechanic. As of today, no federal guidance, notice, or enforcement signal has addressed the PTET route. Notice 2018-54 was aimed at the charitable-fund route and does not cover the PTET structurally, because the entity-level tax is paid by the entity, not by the individual in exchange for a credit.

Why Treasury has not (yet) moved on PTETs

The quiet from Treasury through the summer and fall has three plausible readings, and practitioners have drawn different conclusions from each.

The first reading is that the PTET is harder to attack on substance. The charitable-fund workaround relied on a taxpayer paying a state something the state already could have charged as a tax, dressed as a gift. Substance-over-form fits that fact pattern in an obvious way. The PTET collects an actual tax from an actual taxpayer (the entity), based on actual income, at a rate specified by a state statute. The entity deducts the tax on its own federal return. The individual's credit is computed downstream. There is no "contribution" for Treasury to recharacterize. Any attack would have to reach the deductibility of a state tax paid by a legitimate taxpayer on its own income, which is closer to the core of §164 than the charitable route.

The second reading is that Treasury does not want to attack something that resembles pre-TCJA state corporate tax planning. S corporations and partnerships have long had state-level alternatives to individual taxation. Composite returns are a version of this. Elective entity-level taxes exist in some form in multiple states going back well before TCJA. Drawing a clean line between a legitimate entity-level tax and a §164 cap workaround requires either statutory change or a broad regulation that Treasury may not want to write in a hurry.

The third reading is that Treasury is waiting for a critical mass of states. Two states with PTETs is still, nationally, a pilot. If ten or fifteen states have enacted some version by mid-2019, the revenue impact is large enough to force a decision. A rule issued now would kill off the mechanic before it scales; a rule issued in eighteen months would have different politics, different case law, and different Treasury leadership.

None of these readings is controlling. The practitioner's job in November 2018 is to advise based on the state of the law now, which is that Connecticut and Wisconsin PTETs are on the books, have no adverse federal guidance, and deliver a federal deduction the individual cap would otherwise deny.

What a pass-through owner should watch

For the 2018 tax year, a Connecticut pass-through member is being assessed the PTET whether they want it or not, and the federal return will need to reflect the entity-level deduction. The form mechanics are still being finalized by the Department of Revenue Services, and composite-return filers have a separate set of adjustments to work through. The 93.01 percent credit does not zero out the individual's state tax, and the gap is where the incidence of any residual tax sits.

For a Wisconsin pass-through, the 2018 election window is narrow. Under 2017 Wisconsin Act 368, the election is made by the entity on its Wisconsin return and applies for the year; it is revocable only with department consent. A calendar-year S corporation filing a 2018 return in March or April 2019 is making the election in the face of proposed federal regulations that have not addressed PTETs one way or the other. The federal position is defensible on the face of the statute and Notice 2018-54. It is not risk-free, and any aggressive position on a 2018 return should be taken with the understanding that a 2019 or 2020 IRS pronouncement could retroactively recharacterize the deduction.

For a pass-through owner in a state that has not enacted a PTET, the 2018 return runs with the individual cap binding. Charitable-fund contributions made after August 27, 2018 generate federal deductions reduced by the state credit received. Charitable contributions made before August 27, 2018 sit in a grey zone pending final regulations. Property-tax prepayments made in late December 2017 for 2018 liability, which Notice 2018-02 largely blessed for taxes "assessed and paid" by year-end 2017, are not a 2018 answer and are not available going forward.

The §199A deduction, the other major pass-through provision of TCJA, partially compensates for the SALT cap for many pass-through owners by lowering the federal rate on qualifying income, but the two provisions do not interact. §199A does not touch §164, and the SALT cap applies to the individual whether or not §199A applies to the business.

The shape of 2019

A dozen state legislatures return to session in January with PTET bills already drafted. The first wave of federal guidance on the proposed charitable-fund regulations will land sometime between late 2018 and mid-2019 as REG-112176-18 is finalized. A decision on the State of New York v. Mnuchin motion to dismiss is expected in the first half of next year. None of those events will fully settle the question, and 2019 returns for 2018 will be filed before most of them conclude.

The working assumption for a multistate pass-through operator right now is that PTETs are a real planning tool in the states that have enacted them, the charitable route is effectively closed for any contribution after August 27, 2018, and the cap itself is still a cap. Everything else is speculation about what Treasury decides to do next, and speculation about federal tax policy is a short-half-life asset in its eighth decade.

Sources

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