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As states continue to search for ways to protect their residents from the Tax Cuts and Jobs Act’s (TCJA) limits on the federal deductibility of state and local taxes, Connecticut may have come up with the most interesting. The idea: The state would impose a new entity-level tax on partnerships, limited liability corporations, and other pass-through businesses and give their owners an offsetting individual income tax credit in return.
Connecticut tax officials argue that the SALT deduction cap of $10,000 does not apply to businesses. Thus, pass-throughs could deduct their state tax from federal taxable income as an ordinary business expense while their owners would receive a credit based on the tax. The business would fully benefit from the federal deduction for its tax payments. Its owners would receive smaller after-tax distributions from the business but would be made whole by the credit.
If the theory holds, the SALT cap would be partially defeated at no cost to anyone—except the federal government. Connecticut officials estimate that a 6.99 percent net receipts tax would preserve about $600 million of the $10 billion in SALT deductions that would otherwise be taken away from state residents under the TCJA.
A nice article in Tax Notes (paywall) describes the plan in detail. And State Revenue Commissioner Kevin Sullivan summarized it to the journal this way: “I call it the virtuous tax circle — no losers, all gainers, and a bit of payback for what I think was the utter disregard of the Congress for the impact of this on states like Connecticut.”
Of course, Connecticut is not the only state looking to reverse the TCJA’s SALT cap. New York wants to replace its (now partially-deductible) individual income tax with a new (fully deductible) business payroll tax. California wants to turn state and local taxes into (fully deductible) charitable gifts to state-organized non-profits that would fund education and other services. But while those ideas would apply to many more taxpayers than the Connecticut plan, they also face difficult technical challenges.
By contrast, many tax lawyers believe Connecticut’s workaround is both legal and practical, though some, including my Tax Policy Center colleague Steve Rosenthal, are not convinced. But even if it works legally, it still has two big problems:
It would protect only owners of pass-throughs, many of whom also are beneficiaries of the TCJA’s special 20 percent tax deduction. By contrast, the plan does nothing to aid workers whose income comes in the form of wages and salaries. The state also is trying to cobble together a California-like charitable contribution scheme that would benefit wage earners. But the fate of that idea is uncertain.
The second problem is that it is bad tax policy. Perhaps it would encourage partnerships and S-Corporations to locate in Connecticut. But it would target most benefits to high-income households who generally would be helped the most by state plans to reverse the SALT deduction cap. And it would inevitably be complicated and create new incentives for people to game the rules by turning themselves into pass-throughs. This is especially true when combined with the TCJA’s 20 percent deduction. The pass-through provisions of the TCJA already have created a confusing mess. New state tax benefits for some taxpayers will only make it worse.
There is nothing new about states imposing entity-level taxes on certain pass-through businesses. Bloomberg BNA lists two dozen states that already do so, one way or another. Other states require partnerships to withhold tax in an effort to capture revenue from their out-of-state owners.
The innovation here is not the tax, but the credit. And, of course, the explicit goal of at least partially defeating the TCJA’s cap on SALT deductions.
Yet, the idea is intriguing. By flipping the tax treatment of partnerships and the like on their head—effectively taxing the entity but not the owner, such a plan raises a million questions. Here are just three: How will out-of-state business owners be treated? Will what is being billed as a plan aimed at helping the owners of pass-through firms effectively open the door to something very different—double state-level taxation of partnerships and similar businesses? And what should we call these firms? After all, once they are taxed at the business level, they really are not pass-throughs anymore.
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