SALT Deduction Limitation Presents Tax Planning Opportunities for High-Net-Worth Investors
The Tax Cuts and Jobs Act (TCJA) of 2017, enacted during President Trump’s first term, capped individual state and local tax deductions at $10,000 ($5,000 for married individuals filing separately), encompassing both income and property taxes. Though set to expire in 2025, we anticipate an extension with a potentially higher cap of $20,000 to $50,000. While this limitation has generally increased federal tax burdens for high-net-worth individuals in high-tax states like California, New York, Connecticut, and New Jersey, strategic tax planning opportunities exist that can create even more favorable outcomes than the pre-TCJA environment permitted.
The Rundown
The TCJA's $10,000 SALT deduction cap has created significant tax challenges for residents of high-tax states who can no longer fully deduct their state and local taxes.
States have developed pass-through entity tax workarounds blessed by the IRS, allowing partnerships and S-Corporations to deduct state taxes at the entity level and bypass the individual SALT cap.
Investors who have structured their investment portfolios in investment partnerships, including family limited partnerships (FLPs), may leverage the SALT workarounds to deduct state income taxes and minimize Alternative Minimum Tax (AMT) exposure when properly effected.
Evolution of State Responses and IRS Guidance
After unsuccessful court challenges to the SALT cap legislation, many states implemented elective pass-through entity (PTE) taxes, allowing partnerships and S corporations (“pass-through entities”) to elect entity-level taxation for state purposes. The IRS validated these approaches in Notice 2020-75, confirming that state and local income taxes imposed on and paid by pass-through entities are deductible in computing non-separately stated taxable income or loss. As you’ll see, this distinction between non-separately and separately stated taxable income proves critical in implementation.
States have adopted two primary approaches to these tax workarounds: the "flow-through approach," where owners receive state tax credits for their share of entity-level taxes, and the "exclusion approach," which reduces owners' state taxable income by the amount taxed at the entity level. Connecticut for example currently assesses a 6.99% PTE tax on the entity’s taxable income, and provides the entity’s owners a 87.5% credit of the taxes paid on their individual tax return (effectively capturing a portion of the federal tax benefit). California's PTE regime levies a 9.3% tax with a full owner credit but limits excess credit carryforwards to five years before expiring.
Generally, the state taxable income subject to the PTE regimes includes all income, gain, loss, or deduction that flows through to a direct partner, member, or shareholder of the entity, including investment items like interest and dividends, capital gains and losses, and 1231 gains and losses.
This broad definition of income subject to the SALT workarounds combined with the IRS Notice’s position that the PTE taxes are non-separately stated deductions opens the door for significant tax benefits for owners of investment partnerships.
The Investment Partnership Opportunity
IRS Notice 2020-75 creates a significant opportunity for high-net-worth individuals who hold their investments (including brokerage accounts, rental properties, etc.) in investment partnerships (typically LLCs taxed as partnerships or Limited Partnerships). By making no distinction between business and investment partnerships, the Notice potentially allows purely investment vehicles to leverage the state passthrough entity tax to deduct state income taxes that would have otherwise been disallowed due to the TCJA’s SALT cap.
The interplay between the SALT workaround and the Alternative Minimum Tax (AMT) creates an unexpected advantage for those utilizing this strategy. Prior to the enactment of the SALT cap, many high-net-worth individuals in high-tax states were subject to the AMT because of their large state income tax deductions. When individuals deduct state tax payments it increases their alternative minimum taxable income, often triggering AMT liability. However, by paying the state taxes through the state PTE workarounds and deducting the taxes at the entity level rather than in the individual tax return, the AMT addback is eliminated at the individual level. This not only preserves the federal deductibility of state taxes but actually improves upon the pre-SALT cap environment by allowing state tax deductions without corresponding AMT exposure.
Legal Framework and Technical Analysis
The legal foundation for investment partnership SALT deductions rests on the IRS Notice, the TCJA House Ways and Means Committee Report accompanying the associated SALT cap, and several complementary arguments. At the heart of this framework is IRS Notice 2020-75, which provides the primary authority for allowing investment partnerships to deduct state income taxes at the entity level.
A critical aspect of Notice 2020-75 is its treatment of the state tax payment as a non-separately stated item. Separately stated items are passed through directly to partners for use on their own returns and then considered under the rules applicable to the individual. Non-separately stated items are included in the partnership’s determination of its taxable income and passed through to its partners as a net number. For example, interest, dividends and capital gains are separately stated items, each appearing on the partner’s Schedule K-1 as a separate number, whereas income and expenses associated with a business are non-separately stated, appearing on the partner’s Schedule K-1 as a net number.
The practical effect is significant – if the PTE tax paid was a separately stated item, it would be reported separately in the partner’s Schedule K-1. It would accordingly be reported as an itemized deduction on a partner's individual income tax return’s Schedule A, subject to the $10,000 SALT limitation (and an AMT addback if the SALT limitation did not exist). Rather, as a non-separately stated item, the deduction reduces the net income reported by the partner on their individual return’s Schedule E, bypassing the SALT cap without increasing the individual’s alternative minimum taxable income.
Congress delegated to the IRS the authority to classify partnership items as either separately stated or non-separately stated (in Internal Revenue Code (Section 702(a)(7)). In the context of SALT deductions, the IRS in Notice 2020-75 takes the position that no substantive statutory justification is required for calling a payment of an entity-level tax a non-separately stated partnership item. Furthermore, the IRS does not distinguish between business and investment partnerships in the Notice. Accordingly, a plain reading of the Notice indicates that even if a partnership is solely an investment vehicle and not engaged in a trade or business, it can still take advantage of the entity-level deduction for state taxes.
The IRS's position draws strength from congressional intent, specifically referenced in a footnote to the House Ways and Means Committee report on the TCJA. This report states that entity-level taxes are to remain deductible, indicating that Congress did not intend the SALT cap to apply to taxes imposed at the partnership level.
Several arguments have been raised questioning the deductibility of state taxes by investment partnerships. However, careful analysis illustrates why these challenges don't prevail under the currently available guidance.
Section 164(b)(6) of the IRC, which established the $10,000 SALT deduction limit, is clearly limited to an individual’s deductions; it doesn't change the law for partnerships and S-corporations. Pursuant to the Notice, the entity-level tax reduces partnership income directly, rather than functioning as an individual deduction. Again, this distinction is crucial - the reduction occurs before the income reaches the individual partner's return, placing it outside the scope of the Section 164(b)(6) limitation applied to individuals.
Some practitioners have argued that deductions appearing above the line on Form 1065 (the Partnership Tax Return) must qualify as trade or business expenses. However, the IRS has taken a broader view in the Notice, stating that no specific statutory justification is required to classify entity-level taxes as non-separately stated partnership items. The IRS had an opportunity to define the “Specified Income Tax Payment” for which the deduction is permitted and chose not to restrict the definition based on the activity undertaken by the partnership. This position is particularly significant for investment partnerships, which might not engage in traditional trade or business activities.
The treatment of these deductions also intersects with passive activity considerations. Under Treas. Reg. Section 1.469-2T(d)(2)(vi), state and local income taxes are specifically not passive activity deductions. Furthermore, for partnerships earning only portfolio income, the passive activity loss rules don't apply at all. This is reinforced by Section 469(e)(1)(A)(i)(II) and Treas. Reg. Section 1.469-2T(d)(2)(i), which establish that deduction items clearly allocable to portfolio income are not passive activity deductions.
The question of separately stated versus non-separately stated items, governed by Section 702(a) and its regulations, presents interesting complexities. Treas. Reg. Section 1.702-1(a)(8)(ii) requires
any item that would change a partner's tax result if it had been broken out as a separately sated item to be reported as a separately stated item. Since the TCJA capped SALT deductions at the individual level, this regulation would naturally indicate that SALT payments made at the entity level should be separately stated so that the SALT cap could apply at the individual level. This would be the case regardless of the activity engaged in by the partnership (business, investment, etc.).
However, to comply with the legislative intent outlined in the House Ways and Means Committee report on the TCJA and with its own Notice, Treasury will need to modify this regulation to classify entity-level state taxes as non-separately stated items. The fact that Congress intended for the cap to not apply to payments made by passthrough entities, combined with the IRS's authority to classify items as non-separately stated under Section 702(a)(7), and that the IRS took such a position in the Notice, provides strong support for the full deductibility of SALT taxes irrespective of the activity carried on by the partnership.
Implementation and Best Practices
Successful implementation requires attention to several key elements. The IRS could presumably apply the economic substance doctrine along with other mechanisms to attack the PTE tax deductions associated with investment partnerships. The IRS has consistently prevailed in the courts challenging taxpayers' claimed deductions where legitimate, non-tax business purposes were absent. Accordingly, it is essential to establish and document legitimate non-tax purposes for the partnership structure. Courts have consistently recognized various valid purposes through significant cases, mostly in the case of Family Limited Partnership structures:
Estate of Purdue v. Commissioner validated asset consolidation and coordination as legitimate non-tax motives. Estate of Shurtz v. Commissioner affirmed creditor protection and efficient management as valid purposes. Estate of Miller v. Commissioner recognized investment philosophy continuation, while Estate of Stone v. Commissioner validated family asset maintenance and equal distribution among heirs to be legitimate purposes for forming investment partnerships.
It is also essential that proper partnership formalities are maintained through the establishment of separate bank accounts, maintaining accurate records, bookkeeping, and capital accounts. Operating agreements associated with the entity should be drafted and respected by the partners, and the general partner(s) or manager(s) should hold and document management meetings and ensure their investment activities align with the stated purposes and philosophy in the partnership agreements.
A Trap For The Unwary – Inadvertent Application of the Investment Company Rules
Contributing appreciated assets (like stocks) to a partnership normally avoids gain recognition. However, IRC Section 721(b) requires partners to recognize gain on their contributions when the transfer results in portfolio diversification and the partnership qualifies as an investment company.
A partnership becomes an investment company when over 80% of its assets are cash, stocks, securities, or similar investments. However, three key exceptions preclude gain recognition:
Identical Portfolios: Partners contributing identical portfolios don't trigger diversification.
Insignificant Non-Identical Assets: Minor non-identical contributions are disregarded. For example, if two partners contribute $10,000 each in identical securities while another contributes $200 in different securities, the small amount is ignored.
Already-Diversified Portfolios: Partners contributing portfolios that each meet both the 25% test (no single issuer exceeds 25% of value) and 50% test (no five issuers exceed 50% of value) avoid gain recognition.
The IRS examines the entire transaction. If transfers are part of a plan to achieve tax-free diversification through multiple steps, the original transfer triggers recognition despite individual steps qualifying for nonrecognition.
Government securities receive special treatment, counting toward total assets without being considered a single issuer, unless acquired solely to avoid these rules.
Words of Caution
In the absence of a clear statute and regulations, the authority for taking this position primarily rests on IRS Notice 2020-75 and the House Ways and Means Committee Report. The IRS Notice, which was released by Treasury on November 9, 2020, indicated that they would release forthcoming regulations regarding the allowance of the deduction for the SALT PTE taxes paid. Until such regulations are proposed, taxpayers can rely on the Notice, potentially retroactively, at which time the regulations would control (to the extent of any differences contained in the Notice).
Should this matter reach judicial review prior to the issuance of these regulations and/or a change in the statute, courts are likely to find Section 164(b)(6)'s treatment of entity-level taxes inherently unclear, regardless of their connection to trade or business activities. In circumstances where the statute is unclear, courts have consistently held that congressional intent in committee reports deserves significant deference, particularly when the report is concurrent with the enactment of the statute.
Accordingly, the TCJA legislative history's clear indication of congressional intent to exclude entity-level taxes from the statute’s limitation would likely carry substantial weight in judicial interpretation. Once established that Congress intended to exempt entity-level taxes from the limitation, the technical aspects, including the classification as a non-separately stated item, would merely serve as administrative mechanisms to implement this congressional directive.
Conclusion
The SALT cap workaround through investment partnerships offers sophisticated investors in high tax states a powerful planning opportunity that requires careful attention to structure and
documentation. Success depends on balancing tax efficiency with legitimate business purposes, proper planning, and careful attention to partnership formalities.
As we approach the scheduled expiration of this limitation, investors should stay abreast of the developments concerning new federal tax legislation extending the cap’s expiration, Treasury regulations, rulings, and notices, along with the associated state PTE tax laws. For those willing to invest in proper structuring, the benefits extend beyond mere tax savings to create comprehensive vehicles for productive investment management, income tax efficiency, and potential estate planning opportunities.
This Toplitzky&Co publication provides information and comments on tax issues and developments of interest to our clients and friends. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide tax advice. Readers should seek specific tax advice before taking any action with respect to the matters discussed herein.
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