SALT Cap Workaround for Pass-Through Entities in Precarious Position

While lawmakers have largely focused on the individual impacts of the state and local tax (SALT) deduction cap, the One Big Beautiful Bill Act (OBBBA, H.R. 1) would also change how certain pass-through entities are treated.

The 2017 Tax Cuts and Jobs Act capped the SALT deduction under Code Sec. 164 at $10,000 for individuals. But because pass-through entities “flow through to the individual,” these entities were also originally subject to the cap, American Institute of CPAs Melanie Lauridsen explained on a June 4 webinar.

But Lauridsen contends that it “was not Congress’ intent to limit partnerships or pass-throughs” in this way. As a result, and “with the blessing of the IRS,” 36 states and some localities enacted laws that allow SALT to be shifted “from the individual to the entity level,” she explained.

PTET SALT deduction may be modified.

Under OBBBA, these pass-through entity tax (PTET) state workarounds would be limited. The original draft of OBBBA that advanced out of the House Ways and Means Committee would have ended the PTET SALT deduction for all taxpayers, according to the NYU Tax Law Center’s (TLC) analysis.

But OBBBA was modified before passing the House to allow some, but not all, taxpayers to continue to take PTET SALT deductions. Specifically, pass-through entities that are Code Sec. 199A qualified trades or businesses could still use the workaround. Meanwhile, those who are a “specified service trade or business” (SSTB) would no longer be able to take PTET SALT deductions.

SSTBs generally are professional service firms whose success stems their owners’ and employees’ skills and reputation. Trades and businesses listed under Code Sec. 1202(e)(3)(A) — including law and accounting firms and medical practices — as well as those involved in investment, trading, or dealing in securities, partnership interests, or commodities are SSTBs. Engineering and architecture firms, however, are excluded from SSTB treatment under 199A.

In addition to this change in treatment of SSTBs, TLC explains that the House-passed OBBBA “only excludes state or local income taxes paid by section 199A businesses” from state and local government workarounds. TLC adds that current version of OBBBA “appears to continue to shut down PTET workarounds that are based on other types of state or local taxes for all pass-through businesses.”

Reactions.

The AICPA, along with CPA groups in 53 states and jurisdictions, urged Senate Finance leadership in a June 6 letter to “retain the ability for all pass-through entities to deduct state and local taxes at the entity level.”

They accuse the House bill provision of targeting certain professions. And the provision runs counter to the Trump administration’s stated goals of job creation and economic growth, say the CPA groups.

Lauridsen also sees the provision as “a direct target” to the way accounting firms are structured. “Oftentimes due to regulations, we can’t even form as a corporation,” she explained, “yet we get penalized” for forming as a pass-through.

But TLC takes a different view. SALT workarounds are “a trifecta of bad policy — benefiting the highest income businesses; leading to big, senseless differences in how different businesses and their owners are taxed; and complicating the tax system,” TLC’s Michael Kaercher contends. And he views existing PTET SALT provisions as “legally dubious.”

While the earlier version of OBBBA might have “shut down these workarounds,” Kaercher and his colleagues say that the last minute change “doubles down on the inequities inherent in allowing PTET workarounds in the first place.” TLC is urging congressional Republicans to revert to the original Ways and Means text or to “another approach that would broadly shut down workarounds and provide parity across taxpayers.”

Saul Ewing’s David Shapiro acknowledged that some have questioned the whether the PTET SALT deduction “was legitimate in the first place.” But regardless, Shapiro told Checkpoint that the House-passed OBBBA “continues the recent trend of trying to design taxes that are favorable to one or more groups and less charitable — or discriminatory — toward others.”

Under the current version of OBBBA, “basically the same groups — the lawyers and the doctors and the accountants and the consultants — who lose the benefit of 199A also lose the benefit of the SALT deduction,” Shapiro explained.

The result is in line with a GOP goal of “weighting everything toward manufacturing and businesses that make stuff,” Shapiro concedes. But at the same time, Republican lawmakers — in proposing repeals of green energy credits, for example — have argued that Congress should not be “picking winners and losers,” he added.

As far as why the House bill provision was revised to treat SSTBs differently, TLC said “it appears that House Republicans either did not intend the bill’s text to work the way it was written, or they have changed course.”

But to Lauridsen, the reason for the change is simple — “it’s a money generator.” And the consequence, she added, “is an indirect increase in the tax rate” for SSTB pass-throughs.

For more on the state and local tax deduction cap, see Checkpoint’s Federal Tax Coordinator ¶ K-4500 et seq.