TOO MUCH SALT? THE NUANCED IMPACT OF THE STATE AND LOCAL TAX DEDUCTION CAP ON PASS-THROUGH BUSINESS TAXPAYERS.

• Date: 22 September 2021
• Author: Kahn, Jeffrey H.,Romney, Miles A.,Treu, John S.
• Published date: 22 September 2021
• Author: Kahn, Jeffrey H.

I.Introduction 341 II.The Law of the State and Local Tax Deduction 345 A. The Diminishing Importance of the State and Local Tax Deduction 345 B. Reaction to the TCJA Cap 349 1. New Yorkv. Mnuchin 350 2. Charitable Tax Credits 354 a. Operation of the Work Around 354 b. The Future of the State Tax Charitable Credit 360 3. New York's Payroll Tax 362 4. Entity Level Taxation 363 III. Empirical Evidence of the Effects of the Salt Deduction Cap From Aggregated Return Filings 364 A. Prior Empirical Research on SALT Deduction 364 B. Aggregated Returns Data 365 C. SOI Changes Analyses 366 D. Results of SOI Changes Analyses 367 IV. Evidence of the Impact of the SALT Deduction Cap on Business Owners from Simulated Tax Return Data 369 A. Research Design for Simulations 369 B. Simulation Results Comparing Multiple Income Levels and Different Entity Types Across High- and Low-Tax States Indicate that Adverse Impacts of SALT Cap are Primarily Among High-Income Taxpayers 373 C. Simulation Results with Additional Income and Variations in Long-Term Capital Gain Amounts Suggest Impact of SALT Cap is Nuanced Even Among High-Income Taxpayers 378 V.Conclusion 385 I. INTRODUCTION

The Tax Cuts and Jobs Act of 2017 (TCJA) implemented wide-ranging structural changes to the taxation of U.S. businesses and individuals. (1) The overall stated purpose of the TCJA was to simplify the Tax Code, broaden the tax base and reduce tax rates. However, a controversial change, particularly for small business owners in high-tax states, involved the imposition of a hard cap of $10,000 on the deduction for all state and local taxes (hereinafter the "SALT cap") (2) At least some form of the state and local tax deduction has existed since the inception of the income tax, but the proliferation of flowthrough entities overtime impacted the nature and extent of the underlying taxes being deducted. The SALT cap limits the deduction for all state and local taxes paid by individual taxpayers, which for most taxpayers will primarily include state income taxes and property taxes on personal residences. However, while the limit applies to individuals, business owners structured as S corporations, LLCs and sole proprietorships take the deduction for state and local taxes paid on business income at the individual level. Therefore, the SALT deduction for many small and closely-held business owners can arise primarily from taxes paid on business income rather than from taxes on wages or personal property ownership. Additionally, because the deduction is based on actual taxes paid, business owners in low-tax states would tend to benefit less from the deduction than business owners in high-tax states. Hence, at least in theory, the limitation would have a greater negative impact on business owners in high-tax states than similarly situated businesses in low-tax states.

A repeal of the Federal SALT cap was a major talking point for many Democrats in the 2018 mid-term election, and the House passed the "Restoring Tax Fairness for States and Localities Act" (HR 5377) in late 2019, even though the proposed legislation was certain to die in the Republican-controlled Senate or face a presidential veto. (3) The White House's stated position was that the SALT deduction disproportionately benefits higher income households; thus, imposing the SALT cap funds tax relief to middle-income households. (4)

Elected state officials from blue states where state taxes tend to be higher are critical of the SALT cap and view it as an unfair disadvantage for taxpayers within their states. Simply limiting a personal deduction as opposed to a business deduction would likely be far less controversial as there is a long history of capping (5) or otherwise limiting (6) personal itemized deductions, particularly for taxpayers at higher income levels. The SALT deduction itself has evolved overtime with respect to the deductibility of sales taxes on non-business purchases. Also, the significant majority of states that have income taxes do not permit a deduction for federal income taxes paid. (7) As such, the limitation might not be particularly controversial as applied only to personal deductions, but the impact on small businesses was viewed as particularly egregious.

State legislators in Connecticut were so concerned over the limitation's impact on local businesses that the state restructured its entire system of flowthrough entity taxation in an effort to permit businesses to continue to take the deduction. (8) Described in detail in Part II below, states considered several other possible workarounds such as a charitable tax credit program or shifting employee taxes to employers. (9)

Prior research modeling the impacts of the SALT cap identifies a differential effect on red- and blue-state (i.e. low- and high-tax state) taxpayers. (10) Specifically, Altig et al. estimate the differential in lifetime spending increases incident to the TCJA, finding the law benefitted red-state taxpayers more than blue-state taxpayers. (11) This differential was most pronounced among the richest ten percent of households where the differential was almost entirely driven by the SALT cap. (12) However, the true impact of the SALT cap on business owners must be determined in the context of other existing tax provisions that already limit or eliminate tax benefits from the SALT deduction. For example, the alternative minimum tax (AMT) and the general limits on itemized deductions can prevent or limit a business owner from benefitting from an otherwise permissible SALT deduction. (13) Alternatively, a business owner that takes the standard deduction derives no benefit from itemized deductions, and the TCJA dramatically increased the standard deduction amount. Hence, the SALT cap may have little or no impact on business owners at low-income levels.

We conduct two analyses to better understand the impacts of the SALT cap. First, we analyze the impact of the SALT deduction more generally based on the Internal Revenue Service's (IRS) Statistics of Income (SOI) data, which provide actual taxpayer data aggregated by income level and location. We find that the highest-income taxpayers in blue states paid 0.4% higher taxes than their red- (or purple-) state counterparts. This effect remains in zip codes with business owners with tax attributes suggesting the sale of their business occurred.

Second, we conduct simulations of various business owner scenarios in two high income tax states (New York and California) and two low income tax states (Texas and Florida). We utilize tax preparation software to prepare various before-and-after scenarios for business owners in high-tax and low-tax states around the enactment of the TCJA. We then had these returns reviewed by tax professionals and revised the tax returns based on guidance received in the review process. We simulate the change in the effective tax rates (ETRs) of taxpayer owners before and after the TCJA under various alternative scenarios, including: (i) in two high-tax and two low-tax states, (ii) at several different income levels, and (iii) among different entity types. Simulated middle- to low-income business owners from high-tax states typically were not impacted at all by the SALT cap because these taxpayers tended to take the higher standard deduction under the TCJA. We then simulate high income taxpayer owners under the alternative scenarios of exclusively ordinary income versus half ordinary income and half long-term capital gains. (14)

Our analyses indicate that business owners with the highest income levels in the highest-tax states with primarily ordinary income are the most severely impacted by the SALT cap. The effect is greatly reduced among high income business owners with significant capital gains that are subject to AMT, and the limitation has no differential effect for business owners at lower levels of income. Taken together, our findings suggest that high income taxpayers in blue states with high levels of ordinary income are the most significantly impacted by the SALT cap introduced under the TCJA. Using this data, we illustrate that repealing the SALT cap alone is not enough if the goal of policymakers is to allow all taxpayers in the high-tax blue states to benefit from the state and local tax deduction.

2. THE LAW OF THE STATE AND LOCAL TAX DEDUCTION

   Section 164 simply states that a taxpayer is allowed a deduction for "State and local, and foreign, income, war profits, and excess profits taxes." (15) Section 164 is required to allow taxpayers to deduct their state and local taxes as otherwise such expenses would be deemed personal and therefore not deductible under the federal income tax system. (16) Section 164 is not applicable to state and local taxes imposed on income that is connected to a trade or business or a profit-seeking venture. Those expenses are deductible under sections 162 (trade or business) or 212 (profit-seeking) and so neither section 164 nor the limitations that apply to that provision have any bearing on those deductions. Any reference in this article to state and local taxes refers to such taxes that are not connected to a trade or business or a section 212 activity.

   1. The Diminishing Importance of the State and Local Tax Deduction

      A deduction for state and local income taxes has been a part of the federal income tax system since the very beginning, (17) although its importance has waxed and waned over the century-plus that we have had a federal income tax. Lately (the past 20-30 years), the importance of the deduction has mostly waned for reasons discussed below. Based on reporting at the time, one could be forgiven for thinking that the TCJA was the near fatal blow for the deduction. (18) As we discuss below, this was a misconception, but the recent election results likely mean an even quicker resuscitation of the deduction.

      Still, throughout the history of the federal income tax, the importance and usefulness...