From the moment of passage of the Tax Cuts and Jobs Act of 2017, Democrats from high tax states began to whine that the capping of the deduction for state and local taxes (SALT) at $10,000 was unfair and unwarranted. House Speaker Nancy Pelosi (D-Calif.) and Sen. Chuck Schumer (D-N.Y.) have been insistent that wealthy taxpayers are entitled to an unlimited federal tax deduction for high taxes these wealthy individuals pay in their home states.
The conversation regarding the appropriateness of an unlimited SALT deduction has continued unabated and is an item of controversy as Congress is discussing both the $1.5 trillion infrastructure bill and the $3.5 trillion “budget” proposal.
Apparently missing from this conversation are legislative actions that have already taken place in high tax states that will allow individuals with non-corporate business income to achieve unlimited SALT deductions beginning in their 2021 federal income tax returns. These already completed legislative actions will not cost the individual states passing such legislation a penny.
Legislation passed in 2021 in high tax states allowing unlimited SALT deduction on business income will likely cost the federal government as much as (a reasonable guess) $35 billion to $45 billion in 2021 and $175 billion to $220 billion over the next five years. The legislation would leave only employees and those with interest and dividend income limited to a $10,000 SALT deduction.
The often-published estimate of the cost of eliminating the $10,000 SALT cap for 2021 is $88.7 billion. This often-repeated estimate was made by the Congressional Budget Office (CBO) in December 2019 before any states passed legislation to allow individuals with business interests to deduct their SALT without limitation. All of this legislative action took place in 2021, more than a year after the CBO published its estimate of the cost of restoration of the SALT deduction as $88.7 billion. This $88.7 billion estimate for the cost of a restoration of an unlimited SALT is obsolete.
As the Trump administration wound down, in November 2020, the Treasury issued a notice stating that if a state taxed a business with more than one owner directly rather than through the owner’s individual tax return, the state taxes applicable to the business would be deductible against the income of the business without limitation. Over the next 10 months, legislatures (mostly Democratic legislatures in high tax states) trying to help their wealthiest residents avoid the $10,000 limitation for SALT gave them the opportunity to pay their state taxes applicable from their businesses through their businesses. This results in full deductibility on their individual federal tax returns. While costing the Treasury billions, these legislative actions did not cost these individual states one penny. In California, the legislation passed unanimously.
Like tax shelter salesmen of yesteryear, the state legislatures have referred to these new opportunities for more than single owner entities as “work-arounds.” The mere change in where an individual’s tax payment is mailed will reduce the federal tax on the individual. The combined impact of these states passing such legislation for their wealthy residents could be considered as the largest tax shelter program in the history of the United States.
There has been little, if any, mention of these state legislative actions that could cost the Treasury hundreds of billions of dollars over the next five years.
It appears unlikely that this loss of funds to the Treasury, which is already in place, is being considered in concert with the infrastructure and budget proposals. It’s sad, but possible, that a loss of hundreds of billions of dollars of federal tax revenues is of no interest in Congress.
The president and Congress each have choices with respect to both the unlimited SALT deduction and the recent legislative actions in high tax states. The president could direct the Treasury to withdraw Revenue Notice 2020-75, which resulted in the high tax states’ legislation and direct the IRS to challenge any individual taxpayer who deducts SALT beyond $10,000 regardless of whether the state taxes were paid through their businesses to state taxing authorities. Congress could include in either the infrastructure bill or the budget language to codify that the state taxes paid by individual businesses is limited to the $10,000 cap. Either of these actions would restore the $10,000 cap on SALT deductions.
With state legislative changes and what will probably be very aggressive use of the individual state legislation, the remaining number of individuals impacted by the SALT limitation will be composed almost solely of exceptionally highly paid employees. And this has the taint of being grossly unfair.
Congress could restore the unlimited SALT deduction. With existing state law, it would appear to be terribly unfair that individuals owning businesses can avoid the SALT limitation while employees would not be entitled to this opportunity. Steph Curry of the Golden State Warriors will earn $46 million in 2022. He will be limited to a $10,000 SALT deduction for his roughly $5.5 million of SALT. A hedge fund partner also making $46 million would be entitled to a $5.5 million SALT deduction, reducing his federal taxes by about $2.2 million relative to Curry. How can this be the goal of federal law?
Congress could restore the unlimited SALT deduction and increase tax rates to reflect this increase in SALT deductions for wealthy taxpayers. Note again, state legislatures have already passed legislation that will cost the Treasury in the neighborhood of $175 billion to $220 billion. If this is ignored, the deficit will increase by this amount.
Or Congress could ignore the issue and allow business owners a tax break while punishing high income employees, many of whom are high-profile athletes.
