How to avoid taxes via a SALT-CAP workaround

The Tax Cuts and Jobs Act (TCJA) of 2017 was billed as a gargantuan tax cut for everyone, and for many it was. For others, the savings were just pennies each year. For many high earners in (mostly) blue states, however, the fine print meant some larger-than-expected tax bills. The $10,000 state and local tax (SALT) cap may increase taxable income for most California homeowners before we even consider state income taxes on average (similar) income.

As a financial planner in Los Angeles who loves tax planning for my clients, I have some good news to share. Technically, a new tax has been introduced in 29 states, including California, which could allow some taxpayers to avoid being tax scammed by the TCJA, aka the Trump tax plan. Read on as we discuss how you might be able to schedule and receive a tax deduction for your state and local taxes paid each year.

How the Trump Tax Plan Raised Your Taxes

While “Tax Cuts” is part of TCJA’s full name, many of my clients in California and New York have seen their tax deductions severely restricted by the Trump tax plan. The $10,000 SALT cap severely restricted tax deductions for homeowners (in relatively expensive areas) and residents of states with moderate to high state income taxes. While nationally, it’s estimated that about 11% of taxpayers take advantage of the SALT deduction, that number is likely far higher in most of California, New Jersey, and New York.

Before the TCJA was enacted, you could deduct all of your state and local tax payments from your federal income taxes. Under the Trump tax plan, your deductions are now severely restricted. For example, if you bought a home in Los Angeles for an average price of $950,000, your annual property taxes would be approximately $11,875. I should point out that many simple track houses (that need work) in many Los Angeles neighborhoods can easily cost $2 million or more.

Assuming you had a job (and income) that allowed you to buy and afford that home, your SALT taxes would be significantly higher. Assuming you made about $150,000 (single), your state income taxes would be around the $10,000 SALT ceiling. While you may have seen your federal tax rates drop with the TCJA, a larger portion of your income is likely subject to federal income tax due in part to the SALT cap. This fact alone makes anticipatory tax planning even more valuable.

Can you relieve the SALT CAPSULE sting?

You can wait for the SALT cap to expire. Assuming no changes are made by Congress, the SALT caps will expire at the end of the 2025 tax year. That leaves you with four more years to get taxed by the SALT cap.

What can you do now to mitigate the tax burden from the SALT cap? Several states (including California) have implemented tax avoidance that could be valuable to some taxpayers. There is a new pass-through entity (PTE) tax that allows your (assuming you have a pass-through entity) partnership, S Corporation (S Corp), to have the SALT deduction cap evade. Crazy that a new tax could actually help you lower your overall tax burden.

How does the PTE tax work?

You’re probably wondering how Pass-Through Entity Tax (PTE) works. To put it as simply as possible, your pass-through entity, as the name suggests, forwards all revenue to partners and shareholders. The income and thus the tax liabilities flow to individual entrepreneurs or shareholders, who in turn pay the entire income tax on the company’s income. The SALT cap of $10,000 applies regardless of company income. To add salt to the wound (pun intended), two married business owners are subject to the same $10,000 combined SALT cap as a single business owner.

The good news is that a PTE tax allows qualifying partnerships and S corporations to pay their state income taxes at the corporate level. This is a tax that you must choose to pay. I can hear you asking through the computer, “Why the EXPLETIVEI HAVE
would a taxpayer choose to pay an optional tax?” Let me explain: the magic here is that PTE tax payments made at the routed entity level turn your SALT taxes into a business expense. Your entity can then deduct the full PTE tax payments against the income before it is passed through to owners and shareholders through the company’s net income, thereby avoiding the $10,000 SALT cap.

To date, I believe 29 states have introduced some form of PTE tax. I won’t bore you with the details of each state’s PTE rules; Consult your financial planner for tax planning, your accountant or another tax professional.

You may also wonder why your tax advisor or so-called financial advisor has not pointed this out to you. Assuming you have a conduit company, your financial advisor may not be aware of this valuable tax planning strategy, especially if that advisor is not a business owner (many advisors are employees of their firms). If you only speak to your taxpayer when filing your tax return, you will likely miss out on the benefits of a PTE. Payments must be made during the tax year. If you wait until your tax return deadline, you’re likely missing out on that valuable tax deduction.

View a PTE control example

John and Mike are 50% associates in a California S-Corp with net income this year of $10 million. If they get lazy and skip tax planning for their S-Corp, they won’t benefit from a PTE election. In that case, each of them would receive a $5 million K-1 that would go towards their personal income taxes. For this example, let’s assume they are both homeowners and have used their entire SALT cap on their property taxes.

The current top federal tax rate is 37%, which means John and Mike would each owe about $1.9 million in federal income taxes. Each of them would also receive a $665,000 state income tax bill. The highest marginal tax rate in California is 13.3%. That puts their marginal tax rate at just over 50% on the state-federal combination. You might be thinking, “Everybody’s still taking home about $2.5 million!!!” That may be true, but paying too much tax is still painful.

How much can you save with the PTE tax?

Let’s assume that Michael and John have done proactive tax planning. They choose to have their S-Corp pay the PTE tax. This will seem painful; Together they have to pay around $930,000 to the state of California through their S-Corp. ($10,000,000 at 9.3% income). Now each would have a reported income of $4,535,000 on their K-1 and their federal income taxes due would drop to about $1.7 million each. As for their California taxes, they would each have to report the full $5 million in income, but each would have a $465,000 tax credit on their individual California income taxes. ($930,000/2 partners)

Let me break down the tax savings for you as I know this can get complicated. Each of her California tax bills would have gone from $665,000 to $665,000 only $200,000. The total tax liability for each partner would drop from about $2.5 million to about $1.9 million. That’s about $600,000 in tax savings for each of them. That’s a drop in income taxes of almost 24% per year.

Some of these numbers have been rounded for readability. Don’t take this article as specific tax advice or a recommendation of any kind. But if you’re a high-income business owner, you need to work with financial professionals who can help you avoid tipping the IRS large.

Related: How an SBLOC Can Extend Your Tax Savings

Do you qualify for a PTE tax?

As with anything taxable, there are rules you must follow in order to benefit from PTE tax. To be eligible for the PTE tax benefit you must have at least two partners, sole proprietorship LLCs are unlikely to be eligible. Tax rates and eligibility criteria vary by state, so check with your tax advisor and financial planner. PTE tax may be mandatory in some states, but in other states like California, PTE is available but not mandatory.

You will likely need to do year-end tax planning to get the maximum benefit from PTE. But as you can see, the tax savings can make the tax planning effort more than worth it.