Pass-Through Business Owners Paid $11 Billion to Tell That Would Avoid Federal SALT Deduction Cap
By paying New York’s new pass-through entity tax, those business owners moved their state income tax from their personal tax returns—where the cap would pinch them—into their business filings, where the cap doesn’t affect them.
The total represents approximately one-sixth of New York’s estimated personal income tax revenue for the fiscal year ending March 31. The result: If those business owners had an average federal tax rate of 32%, they would be saving more than $3 billion.
New York’s effort to help business owners dodge the cap is the latest and most effective move by high-tax states to fight against the $10,000 limit on the deduction of SALT, or state and local taxes, from federal income. Congress capped Democratic objections to the 2017 tax law, and lawsuits and other workarounds fell short. The federal law to raise the cap has been implicated in intra-Democratic party feuds in Washington.
Meanwhile, some of New York’s biggest law, financial and accounting firms route their partners’ income through the state’s deregulation, which took effect last year. The tax department said about 96,000 filers used the program.
“It’s a huge number,” said former New York tax commissioner, James Wetzler. The take-up is much greater than other workarounds, he said, including a program that lets employers pay federal deductible payroll taxes to help their employees lower income taxes. According to the state, that program had 328 users in 2021. The Trump administration came up with another solution that relied on people making charitable contributions in exchange for taxes.
Tax Department spokesman James Gazelle declined to comment beyond providing figures for 2021.
New York Assemblywoman Amy Palin, a Democrat from Westchester County, sponsored legislation to create a workaround she adopted as part of the state budget last year. He said the widespread use of the pass-through program showed an inconsistency in a 2017 federal law.
“You had to be a fool for not taking advantage,” she said. “New York was hurt by the change in SALT and it was a way to make up for that loss. Otherwise our big earners would run away.”
States such as Connecticut and Wisconsin have previously enacted similar laws. This move from New York, home to many of the highest-income business owners, is particularly significant.
Details vary by state, but here’s how the workaround usually operates. States impose a tax—often optional—on pass-through entities such as partnerships and S corporations, a tax designation for some closely held businesses. Those taxes are paid and deducted before income flows to business owners, effectively creating an unlimited deduction.
Laws use tax credits or other mechanisms to exempt owners of personal income-tax liabilities from business income. Thus, they meet state income tax obligations without generating income tax deductions subject to federal limits.
State revenue is virtually unchanged, as unit-level taxes replace personal income taxes at roughly the same rates. Business owners win because each $100,000 in new deductible state taxes reduces federal taxes by $37,000. The federal government loses money.
The workaround put pass-through businesses more level with corporations, which deduct corporate income taxes entirely.
New York has a top-heavy income tax base where the highest-earning 2% of filers account for almost half of their revenue. A significant portion of this now flows through this alternative route available to owners of pass-through businesses.
The state’s top income tax rate for tax year 2021 increased to 10.9% for incomes over $25 million.
New York is one of 22 states According to the Main Street Employers Coalition, a business group that pioneered the idea, pass-through has adopted similar systems to help business owners achieve the $10,000 cap. Congress created the cap to generate money to pay for the tax rate cuts. Republicans say the old unlimited deduction subsidized high-tax states, because federal taxpayers were bearing part of the cost of the state tax increase.
Democrats opposed the cap for political gains in New York and New Jersey in 2018, but they have yet to repeal or extend it. The House passed a bill last year that would raise the limit to $80,000, but it has stalled with the rest of President Biden’s Build Back Better agenda in the Senate.
New York and several other states also filed a federal lawsuit alleging that the cap was unconstitutional. It has failed at the district and appeals court level. Last week, the states had asked the Supreme Court to hear the matter.
This pass-through workaround for CAP, unlike other approaches, has been bipartisan and spread across Republican and Democratic states. The Treasury Department blessed it in 2020. The Biden administration, which has mostly left the issue to Congress, has shown no public interest in reversing that decision to strengthen enforcement of the border.
“The cap is still, for the most part, doing its job. It is unfortunate that states are going to such lengths to try to protect their high-income earners from paying federal taxes,” said one responsible in Washington. Mark Goldwyn, senior vice president of the committee for the federal budget, said. “It feels like a win-win when you don’t account for the federal revenue portion of it.”
Kathryn Wylde, president and chief executive of Business Group Partnerships for New York City, said the program was highly effective for the state and called for New York City to make a similar allowance for its local income tax.
“These are accounting firms, law firms, financial firms—and they are many people who are at risk of losing New York State on the basis of a very high tax burden with very limited deductions,” she said.