Deciphering the SALT Workaround

The state and local tax (SALT) deduction permits taxpayers who itemize when filing federal taxes to deduct certain taxes paid to state and local governments. However, the 2017 Tax Cuts and Jobs Act imposed a $10,000 SALT itemized deduction limit. This affected California in particular because of the high-income tax rates in the state.

What is a SALT Workaround?

IRS Notice 2020-75 pointed out that in the case of pass-through entities (PTEs), such as partnerships and S corporations, the owner reports a share of the entity’s profits. The notice generally provided that for state tax payments made on or after November 9, 2020, the tax payment will reduce federal taxable income to that partner. Owners of eligible entities can deduct a more significant portion of their state income taxes paid against federal income. Even before the notice, states developed the idea of the workaround. Now, a little over half of the states in the U.S., including California, have a SALT workaround.

Should a Trustee Take Advantage of SALT Workaround?

Beneficiaries usually benefit from taking advantage of the PTE tax deduction- there would probably be no damages if the trustee does so. For the tax years ending before 2026, trustees should communicate the tax consequences to the income beneficiaries. Income beneficiaries may need to adjust their personal withholding taxes if the trustee takes advantage of the SALT workaround.

We note that a remainder beneficiary could be “damaged” if the SALT workaround is used. For example, assume a PTE has $1 million of taxable income. California’s PTE rate is 9.3%. Thus, this would mean the PTE could pay up to $93,000 of CA state income tax. If the entity pays this amount, the federal income tax reported to the income beneficiary would be reduced by $93,000. This is what gets around the SALT limitation. However, the entity now has $93,000 less cash, which might arguably reduce what the remainder beneficiaries receive one day.

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