Some high-tax states aim to provide businesses workaround for SALT limits

Some states are changing the tax laws for unincorporated businesses such as partnerships to enable pass-through entities to circumvent the $10,000 limit on state and local tax deductions in the Tax Cuts and Jobs Act.

Connecticut has already adopted such legislation and New York State recently proposed it as well. The state laws promise to reduce the U.S. federal income tax liability of the owners of some types of pass-through businesses by taxing the businesses directly, instead of their owners.

“The intended benefit of these laws, at least as envisioned by state legislators, is that if you have an unincorporated business, which is an entity that is taxed as a partnership, the entity itself will pay some or all of the state taxes owed that would have been paid by the owners under prior law,” said Brett Cotler, an attorney in the taxation group at Seward & Kissel in New York, which issued a client alert on the topic last month. “That includes LPs, LLCs and multimember LLCs. I believe Connecticut includes S corporations in that definition as well, but New York’s currently does not. Those taxes paid by the entity will be treated as an ordinary and necessary business expense that would be deductible when those items flow up to the owners. When they’re deductible as a business expense, those state taxes would not be subject to the $10,000 limitation on deductibility of state and local taxes, which was a new limitation that came into the code as a result of the Tax Cuts and Jobs Act.”

A printout of Congress's tax reform bill, "The Tax Cuts and Jobs Act," alongside a stack of income tax regulations

New York is still taking comments on the proposal. Connecticut adopted the change at the end of May and it’s effective for the current tax year, and for other tax years beginning on or after Jan. 1, 2018. New York’s proposal wouldn’t take effect until 2019 at the earliest, according to Cotler.

New York has already passed several other workarounds for the limits in the new federal tax law on deductibility of state and local taxes, including a state-run charitable fund and an optional payroll tax system (see New York tax law changes respond to new federal tax law). However, the IRS and the Treasury Department have already issued a notice indicating they will be issuing guidance challenging the state-run charity workaround (see IRS and Treasury plan crackdown on SALT deduction workarounds).

“I think they're all motivated by that same desire to get around those limitations,” said Cotler. “Whether these laws are going to be effective is another story entirely. The IRS, as previously stated with respect to the charitable funds that states are contemplating, might not respect it, and there’s a chance the IRS might say these unincorporated business taxes don’t have substance and they’re purely on the books to get around federal tax rules. They might take some type of federalist argument, ignore these and deny the deduction for those taxes paid. I don’t think the IRS would challenge it on a state-by-state basis. I think they’ll just put out guidance that says if your state has done this, then this is how you should treat your federal tax return. I think they will take a very global approach that way.”

New Jersey recently amended its tax laws and raised the top marginal rate for New Jersey taxpayers to 10.75 percent for income over $5 million, although it didn’t make any changes for unincorporated business taxes.

“It’s a pretty high state income tax rate, but they also imposed a contingent tax on carried interest,” said Cotler. “I think that would have been the opportunity for New Jersey to adopt or at least look at something similar to the New York and Connecticut unincorporated business taxes. Maybe there’s something to read between the lines in the fact that they didn’t.”

His firm recently issued a client alert about New Jersey’s changes in taxation of carried interest, which go further than the federal tax law in closing off the tax break. The Tax Cuts and Jobs imposed a three-year holding period for capital gains before allowing the carried interest tax break.

“They made it a three-year holding period, so that effectively carved out real estate funds because they’re typically a long-term holding strategy anyway, and they carved out most private equity funds” said Cotler. “It also doesn’t affect a lot of actively traded strategies either because everything there was always short-term capital gains anyway. But it does affect a lot of our hedge fund clients that had a kind of value type of strategy where maybe they did a little bit of trading around the side, but they had a core portfolio of assets that they held for longer than one year, but would not necessarily meet the three-year holding period. So it doesn’t go all the way to closing down the treatment of carried interest as investment income rather than compensation income.”

In contrast, the New Jersey law effectively removes the carried interest tax break, at least for New Jersey taxpayers, but it won’t take effect until three other states adopt similar laws, in order to discourage wealthy taxpayers from simply moving.

“The New Jersey law certainly takes it all the way, because it’s a 17 percent additional tax on carried interest,” said Cotler. “And that would effectively bring a 20 percent tax rate, which is the capital gains tax rate for federal, to 30 percent, which is the ordinary income tax rate at the federal level. I think there are some flaws in how New Jersey drafted it, so if it ever became effective I would certainly want to see some drafting changes to the law just so we know that it’s not 17 percent on all carried interest, and it’s only 17 percent on the portion that’s taxed at the lower federal rate. But the New Jersey law isn’t effective until Massachusetts, Connecticut and New York all enact similar legislation, and none of them have so far.”

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