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Abstract

The Tax Cuts and Jobs Act (TCJA) enacted a $10,000 cap on the State and Local Tax (SALT) deduction on Form 1040, Schedule A. Had this cap been implemented a year earlier, it would have impacted some 10.9 million taxpayers and would have disallowed approximately $323 billion in deductions. It was also projected that during the duration of the cap, New York taxpayers alone would pay approximately $121 billion more in federal taxes, and the state revenue would greatly suffer. In response to the cap , and as a result of its impact, states established certain workarounds, the most popular being the pass-through entity tax. Under a pass-through entity tax regime, the state levies tax on the pass-through entity, and the individual excludes the taxed income on their state return or receives a credit for the taxes paid by the entity. First and foremost, this workaround immediately changes how pass-through entities are taxed. Instead of treating them as conduits of profit and loss—conforming to federal tax treatment and the way the entities have historically been taxed—the states have mixed the theories of taxation and have applied the entity view of taxation at the state level while the businesses are still taxed in accordance with the aggregate view on the federal level. Thirty-six states have enacted some variation of the workaround. This has complicated the filing and record-keeping for businesses. Also, each state law has nuances and differences. This makes tax compliance and record-keeping extremely complicated for businesses, especially with a mix of resident and non-resident owners. All things considered, the pass-through entity tax regimes generally apply different theories of business to the same income between federal taxation and state taxation. The laws disconnect the principles of profits and losses being taxed at the same level to which they are allocated, whether at the entity level or the individual level. They circumvent the goal of the TCJA to simplify the tax code, instead making it much more complex for pass-through entities and their owners. Finally, because the pass-through entity taxes circumvent the SALT cap, it also causes a reduction in federal tax revenue. For these reasons, Congress should enact a provision to require the income tax paid by a passthrough entity for which the owners receive some benefit (either an exclusion or credit) to be separately stated on the entity’s return and subject to the SALT cap on the individual return. This will prevent the loss in federal revenue and will dissuade businesses from electing to be taxed at the entity level, thereby preserving the simpler filing and record-keeping that existed prior to the pass-through entity tax workaround.

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