There are always “legal” tax scams for the truly wealthy. That’s one reason they use power, influence, and money to continue their power, influence, and money.
Sometimes they get caught, though, like with the Tax Cuts and Jobs Act of 2017—legislation rushed through by a GOP Congress that favored corporations and the wealthy with even more beneficial treatment. The so-called SALT—state and local taxes—deduction on federal income tax was limited. But then you can count on people in power trying to ease the pain for those who would feel it least.
Technically, it hit everyone living in higher tax jurisdictions. There was now a hard limit on the collected amount of these taxes that could lessen one’s income on a Form 1040. Many people living in high-tax locations, like New York, New Jersey, California, Texas, Illinois, and Pennsylvania. Millions got caught up in this. One might reasonably say that a limit on the deduction, given that this tax treatment is largely used by upper middle class and wealthier persons, was reasonable.
Everyone got dinged. Except, it turns out that isn’t true. New York University School of Law professor Daniel Hemel recently pointed out that 29 states “enacted laws since 2018 that are designed to provide passthrough entity owners with an unlimited federal tax deduction for state and local business income taxes.” (Tip of the hat to Lever News for noting this.)
Passthrough entities are legal business structures—partnerships, solo proprietorships, limited liability companies, and S-corps—that pass taxes owned directly onto the people who own the businesses. It’s to prevent effective double taxation. Passthrough entities allow a lot of favorable treatment; this is an additional one.
The way it works is that these states created “passthrough entity taxes,” or PETs, that partnerships and S-corps could opt to pay into. They pay “an entity-level state income tax in exchange for a dollar-for-dollar benefit on their owners’ state personal income tax returns.”
The IRS has offered guidance that it would let such companies claim an “entity-level deduction for PET payments” and remove those taxes from the individual-level $10,000 SALT cap.
But there is a problem. If Hemel is correct, these exceptions for passthrough entities are schemes used by the states to protect the interests of the very wealthy—because this is a case where you need money to get experts to structure such mechanisms of avoidance—are probably not legal.
“Under the plain text of the Internal Revenue Code, the workaround does not work,” Hemel says. “The December 2017 law clearly precludes passthrough entities and their owners from deducting state and local income taxes beyond the $10,000-per-individual cap. And the legislative history of the December 2017 law—read in context—aligns with the statutory text.”
He further says that the IRS hasn’t provided a rationale for its stance and, also, that no one has legal standing to challenge this in court. That reads remarkably like something struck from an early draft of Catch-22 because it would have sounded too crazy to believe, even in fiction.
Hemel said that the apparently illegal break will cost the federal government more than $50 billion by the end of 2025, and that most of the benefits will go to those whose incomes top $1 million. The guidance means that partnership and S-corp owners can claim “an unlimited deduction for state income taxes while wage-earners and sole proprietors remain bound by the $10,000 cap.”
Was this all a mistake? Probably not. Another New York University School of Law professor, David Kamin, warned of the problem in November 2017, saying that it seemed the House was intentionally creating this benefit.
“According to the Ways and Means Committee section-by-section: ‘Under the provision, individuals would not be allowed an itemized deduction for State and local income or sales taxes, but would continue to be entitled to a deduction for State and local income or sales taxes paid or accrued in carrying on a trade or business or producing income,’” he wrote.
A state- and federal -enabled scam seems to be the only fair description. But then, is that any surprise?