In response to the Tax Cuts and Jobs Act of 2017, many states have enacted elective entity-level passthrough taxes that allow business owners to circumvent the individual cap on deductibility of state and local taxes (SALT), reducing federal tax revenue at no cost to the states. Entity-level workarounds purport to shift state income tax liability from the owners’ personal tax returns to the entity’s tax return. The passthrough entity claims an uncapped ordinary business deduction for state income taxes, reducing the owners’ adjusted gross income for federal tax purposes; state income tax credits roughly equal to the entity-level tax reduce or eliminate the owners’ state tax liability. In Notice 2020-75 the outgoing Trump administration blessed entity-level workarounds, violating fundamental principles of conduit taxation that seek to treat passthrough owners as if they conducted the entity’s business individually. Because elective entity-level taxes function as nearly perfect substitutes for individual income taxes, they should be required to be separately stated and deducted at the individual level, subject to the SALT cap. Allowing passthrough owners the equivalent of an above-the-line deduction for state income taxes is inconsistent with the concept of adjusted gross income which Congress introduced in 1944 to establish rough parity between business and nonbusiness taxpayers regardless of source of income. Notice 2020-75 conspicuously fails to explain why the separate statement rules do not apply to elective entity-level taxes; it also ignores longstanding guidance concerning the business–nonbusiness distinction and the meaning of “state taxes on net income.” Whether or not Congress retains the SALT cap, Notice 2020-75 should be rescinded.
Since 2018, over three-fifths of the 50 states have adopted entity-level workarounds that allow passthrough owners to circumvent the individual limit on deductibility of state and local taxes (SALT). These newly-created passthrough entity taxes (PTETs) purport to shift state income tax liability from the owners’ personal tax returns to the entity’s return, saving billions of dollars in federal taxes for wealthy individuals. Similar to a corporation, the passthrough business claims an uncapped deduction for ordinary business expenses for the payment of taxes, rather than a capped SALT deduction. To offset the entity-level tax, the owners receive credits, exclusions, or other state benefits roughly equal to the taxes paid by the entity. State revenue is unchanged or even enhanced, since the entity-level tax at least fully replaces the uncollected personal taxes. Red and blue states alike have responded to demands for “SALT parity” for high-income business owners, draining federal revenue and exacerbating tension over how to reform the SALT cap. During the waning days of the previous administration, the Internal Revenue Service (the Service) gave its blessing to entity-level workarounds in Notice 2020-75 and created a dilemma for the current administration: any attempt to revoke the Notice will encounter stiff opposition from business owners and from states that have distorted their own tax regimes by enacting PTETs.
In focusing on the SALT cap, Notice 2020-75 distracts attention from a more fundamental problem: the entity-level workarounds subvert legislation enacted in 1944 which sought to provide equitable treatment of business and nonbusiness taxpayers, regardless of the source of income. Part II of this article explores the underpinnings of the 1944 legislation in the context of developing a mass income tax and reducing the complexity of prior law. Part III illustrates how PTETs function as nearly perfect substitutes for individual income taxes by disaggregating disparate owners in the most tax-efficient manner based on their specific tax characteristics. Part IV confronts specious arguments advanced by workaround proponents, culminating in Notice 2020-75, that longstanding Service policy allows business income taxes to be deducted at the entity level. Part V traces the evolution since 1945 of the Service’s ruling policy that draws a clear distinction between business income taxes and other business taxes, consistent with Congress’s original goal of imposing a uniform tax burden on owners and employees. Part VI concludes that the Notice is deeply flawed and should be rescinded.
Section 164(b)(6), added in 2017, imposes an aggregate cap of $10,000 on an individual’s deduction for state and local taxes. Section 164(b)(6) limits most individual taxpayers to an itemized deduction of $10,000. The SALT limit does not apply, however, to state and local real property and personal property taxes if paid or accrued in carrying on a trade or business or investment-type activity that qualifies for a deduction under sections 162 or 212. Presumably the rationale for this exception, which benefits mostly wealthy passthrough owners, is that business and investment SALT deductions reflect expenses incurred in earning taxable income. Capping nonbusiness SALT deductions is arguably justified because such taxes are properly viewed as consumption.
The net result is that individual state and local income taxes (other than foreign taxes) described in section 164(a)(3) are subject to the SALT limit, even if paid or accrued in carrying on a trade or business. The exceptions to the SALT limit for real property and personal property taxes, under the flush language of section 164(b)(6), underscore that individuals engaged in a trade or business cannot avoid the cap by claiming that excess state income taxes are deductible under section 162 or section 212. The legislative history confirms that individual taxpayers cannot deduct state income taxes in excess of the cap, even if such taxes are incurred in a trade or business or investment-type activity. Because section 164(b)(6) applies only to “individuals,” corporate taxpayers may continue to deduct state income taxes without restriction.
The deduction for individual state and local taxes has long proven controversial. By contrast, it is “generally taken for granted that business taxes should be deductible by the businesses that pay them.” It would be possible to level the playing field by denying a deduction for general state income taxes for corporate as well as passthrough businesses. Since all businesses are owned ultimately by individuals, such an approach would treat different entity types and their owners alike. Given the unfavorable treatment of individual taxpayers, the SALT limit is inherently unstable. While business activity conducted by C corporations declined prior to 2018, passthrough businesses now represent more than half of all business activity and are disproportionately owned by high-income individuals. The 2017 Act virtually invited the emergence of entity-level workarounds designed to convert nondeductible individual state income taxes into deductible business expenses. Not surprisingly, states responded by crafting mandatory or elective regimes that shift the nominal burden of state income taxes to passthrough entities (PTEs) and away from their owners.
Elective workarounds treat entity-level taxes as fully deductible ordinary business expenses rather than capped SALT taxes, thereby cabining any deduction at the entity level. If the deduction is properly subtracted in determining passthrough taxable income, entity-level taxes reduce the individual owners’ reported income. Thus, confining the deduction at the entity level allows state income taxes to disappear on the owners’ individual tax returns through the mechanics of computing passthrough income. Put differently, the technique transforms what would otherwise be an itemized deduction at the individual level, subject to the section 164(b)(6) limit, into the functional equivalent of an above-the-line deduction for purposes of determining the owners’ adjusted gross income (AGI). The goal is not only to circumvent the section 164(b)(6) limit but also to preserve a full standard deduction under section 63. Elective workarounds conflict with the AGI concept and with basic conduit principles.
The different treatment of business and nonbusiness taxpayers stems from the concept of AGI, which was originally enacted in the Individual Income Tax Act of 1944. Section 62 lists above-the-line deductions that are allowed in computing AGI. For individual taxpayers, state and local taxes are generally allowed in computing AGI only if such taxes are (1) “attributable to a trade or business carried on by the taxpayer” (other than one consisting of performance of services by the taxpayer as an employee) or (2) “attributable to property held for the production of rents or royalties.” Otherwise, such payments are allowed only below the line as itemized deductions and are disallowed if the taxpayer claims the standard deduction.
Under section 62(a)(1), longstanding regulations provide that above-the-line deductions allowed in arriving at AGI consist only of those expenses that are “directly, and not those merely remotely, connected with the conduct of a trade or business.” The regulations further state that, under section 62(a)(4), “taxes are deductible in arriving at AGI only if they constitute expenditures directly attributable to a trade or business or to property from which rents or royalties are derived.” For purposes of section 62, the regulations distinguish between, on the one hand, “property taxes paid or incurred on real property used in a trade or business,” which reduce AGI, and on the other hand “state taxes on net income,” which do not reduce AGI “even though the taxpayer’s income is derived from the conduct of a trade or business.” Thus, individual state income taxes levied on business (or investment) income are considered nonbusiness expenses for purposes of section 62.
While nonbusiness treatment of such expenses may appear “counterintuitive,” it is firmly rooted in the rise of the modern income tax as a mass tax during the Second World War. In response to wartime pressures and the need to simplify the income tax, Congress in 1944 adopted an “optional standard deduction” and also introduced the AGI concept. To ensure equitable application of the optional standard deduction, it was essential to put all taxpayers on a roughly comparable basis before deductions. Thus, Congress believed it was necessary to distinguish between business deductions—allowed in determining AGI—and all other deductions for which the optional standard deduction was a substitute; nonbusiness deductions were allowed only as subtractions from AGI in arriving at taxable income.
By drawing a line between business and nonbusiness deductions, the new AGI concept came “closer than any previous definition used in tax legislation to what many economists would consider net income.” Under the simplified system, nearly one-half of all taxpayers were able to determine their tax liability using an expanded tax table, without actually computing their individual tax. The 1944 reforms represented a “landmark” in U.S. tax history, and the AGI concept has proved surprisingly durable. In later years, the coherence of the 1944 distinction between business and nonbusiness deductions for AGI purposes began to erode. Congress introduced some above-the-line personal deductions, while deductions such as alimony migrated above or below the line in response to changing tax policies.
The 1944 legislative history indicates that Congress intended to establish rough parity between employees and business owners for purposes of calculating AGI. According to the Senate report:
Fundamentally, the deductions thus permitted to be made from gross income in arriving at adjusted gross income are those which are necessary to make as nearly equivalent as practicable the concept of adjusted gross income, when that concept is applied to different types of taxpayers deriving their income from varying sources.
A merchant or store owner might have significantly higher gross income (defined as gross receipts less cost of goods sold) than a salaried employee; thus, a deduction for business expenses was necessary to put them both on the same footing for purposes of “equitable application of a mechanical tax table or standard deduction which does not depend upon the source of income.” Similarly, gross income derived from rents and royalties was reduced by associated deductions to create parity with interest and dividends which were taxed in full.
Trade-or-business deductions allowed in computing AGI were “limited to those which fall within the category of expenses directly incurred in the carrying on of a trade or business. The connection contemplated by the statute is a direct one rather than a remote one.” This requirement excluded deductions that were merely proximate to a trade or business: “For example, property taxes paid or incurred on real property used in the trade or business will be deductible, whereas State income taxes, incurred on business profits, would clearly not be deductible for the purpose of computing adjusted gross income.” Similarly, Congress intended the “attributable to” standard under section 62(a)(4) to apply in its “restricted sense” for purposes of determining above-the-line deductions incurred in the production of rent or royalties. The Treasury explicitly incorporated this Congressional understanding in the regulations, which have remained virtually unchanged since they were first promulgated in 1945. Under the 1944 legislative history and implementing regulations, it was clear that, for purposes of section 62(a)(1), individual state income taxes were not “attributable to” the taxpayer’s trade or business and thus did not reduce AGI.
Prior to 1944, no clear distinction was drawn between state income taxes as a personal or business expense. For purposes of deducting state income taxes, the 1944 reforms placed sole proprietors at a disadvantage compared to incorporated businesses for which the AGI concept was not relevant. Given the double-level tax system, however, sole proprietors were unlikely to have an incentive to incorporate; indeed, state law barred many professionals from incorporating. Moreover, a sole proprietor continued to obtain an above-the-line deduction under the predecessor of section 62(a)(1) for non-income state and local taxes (such as franchise taxes). Immediately after the 1944 reforms, one commentator noted uncertainty concerning whether ordinary and necessary business expenses should include “state income tax on the business net income, even though this might be held by some not to be a cost of the business.” Following the 1944 legislation, the Service sought to clarify application of the “attributable to” standard and the meaning of a “state income tax” for purposes of section 62, consistent with Congress’s intent to treat different taxpayers equitably regardless of the source of income.
Under the passthrough rules, partnerships and S corporations compute their taxable income in a manner similar to that of an individual. Deductions for certain items, including foreign taxes and charitable contributions, are disallowed at the entity level, since these items are allowed directly to the owners on their personal income tax returns. For example, charitable contributions made by a partnership do not reduce partnership taxable income but instead pass through to the partners on their personal income tax returns. Although passthrough businesses determine their income in much the same way as individuals, the AGI concept does not apply. Unlike charitable contributions or foreign income taxes, the statute does not specifically disallow an entity-level deduction for state income taxes.
An individual partner or S corporation shareholder should be treated, to the extent administratively feasible, in the same manner as if the individual had earned a distributive share of the entity’s income directly. Under the rules of sections 702 and 1366, an item of income or loss must be taken into account separately if proper treatment of the item could be affected by the owners’ tax characteristics. For example, separately stated items include capital gains and losses, section 1231 gains and losses, charitable contributions, dividends eligible for preferential capital gains rates under section 1(h)(11), foreign taxes, and any other items prescribed by regulations. The separate statement requirement generally ensures that passthrough deductions will be tested at the individual level, subject to whatever individual limits apply.
Items of partnership taxable income or loss which are not required to be separately stated fall into a residual category referred to as “bottom-line” items. The rationale for not requiring bottom-line items (including most trade-or-business expenses) to be separately stated is that they generally do not make any difference in the tax treatment of such items at the owner level. On their personal income tax return, each owner must report his or her distributive share of separately-stated and bottom-line items as shown on the entity’s information return (Schedule K-1). Since all items must eventually be reported, classifying items as separately or non-separately stated may be viewed merely as an administrative convenience. Allowing certain items to be combined at the entity level simplifies reporting of the owners’ respective shares of the entity’s tax items. In theory, however, it should not make any difference if all items were instead treated as separately passing through to owners for purposes of determining their individual tax liabilities. Entity-level workarounds violate basic conduit principles that generally treat passthrough owners as if they conducted the entity’s business individually.
Workarounds seek to take advantage of the status of partnerships and S corporations as entities separate from their owners for certain purposes. At the owner level, the economic burden of state income taxes is unchanged, even though the formal incidence is shifted. Under the various PTET regimes, a mandatory or elective entity-level tax, coupled with an offsetting individual income tax credit (or exclusion), purportedly allows passthrough owners to receive the benefit of an uncapped deduction for state income taxes. If allowable as a section 162 deduction for a trade-or-business expense, entity-level taxes reduce the owners’ distributive shares of taxable income, resulting in the equivalent of an above-the-line deduction for purposes of section 62. Since such taxes are subtracted from entity-level income (and are not separately stated), the individual owners escape the section 164(b)(6) limit and may also claim the standard deduction.
Example (1): The entity-level workarounds can be illustrated quite simply. Assume that a state imposes an elective 10% income tax on passthrough entities equal to the maximum state individual rate. The entity’s owners receive a dollar-for-dollar credit for their share of entity-level taxes, which must generally be added back for state tax purposes. An equal two-person partnership has $2 million of income before taking into account entity-level state income taxes of $200,000 ($2 million × 10%), which reduce the partnership’s taxable income to $1.8 million. Both partners are individuals who are subject to the maximum 10% state tax rate on individual income. For federal tax purposes, each partner includes her $900,000 distributive share of partnership income ($1 million less $100,000 section 162 deduction for taxes paid). For state income tax purposes, each partner reports taxable income of $1 million ($900,000 plus $100,000 credit for taxes paid) and a tentative tax liability of $100,000; after applying her share of the state tax credit ($100,000), each owner’s state tax liability is reduced to zero. Thus, for state tax purposes, the partners’ income is unaffected by the federal deduction for entity-level taxes, while the credit eliminates any state tax obligation on each partner’s share of the full $1 million of pre-tax income.
The entity-level workaround is revenue neutral from the state’s perspective but saves federal taxes of $37,000 ($1,000,000 × 37%). The partners have effectively transformed nondeductible individual state income taxes on their share of passthrough income into a deductible expense at the entity level; the section 162 deduction yields the equivalent of an above-the-line deduction for AGI purposes. By this alchemy, the partners hope to escape the SALT limit and preserve an undiminished standard deduction. Had the partners operated the partnership’s business directly, section 62 would disallow an above-the-line deduction for state taxes on income derived from a trade-or-business activity. Characterizing the entity-level deduction as a non-separately stated section 162 expense allows an end run around the AGI concept; for federal tax purposes, an amount equal to the entity-level tax is excluded from individual gross income. Entity-level taxes are treated as fully deductible trade-or-business expenses rather than capped state and local taxes, avoiding the section 62 limit and accomplishing the same result as if Congress had never codified the AGI concept.
Example (2): In Example 1 above, assume that the entity is an S corporation with a single owner. The state taxes the entity’s income at a rate of 6.99% (the maximum individual rate) and offers a credit equal to 93.01% (100% less 6.99%) against the owner’s state income tax liability. If the credit is not added back in determining state income, the partial credit nevertheless reduces the S shareholder’s state tax liability to zero and preserves state revenue neutrality. Since the S corporation shareholder bears the economic burden of the entire entity-level tax, the credit (93.01%) merely relieves state tax on the owner’s distributive share of partnership income net of state taxes (100% − 6.99%). The entity-level tax is revenue neutral for state tax purposes, since the entity pays taxes of $139,800 ($2 million × 6.99%) equal to the amount that the owner would otherwise owe, and the credit washes out the owner-level tax. Deducting the entity-level tax, however, yields federal tax savings of $51,726 ($139,800 × .37).
From the states’ perspective, there is no reason to allow passthrough owners to capture the entire federal tax savings from the entity-level workaround. By reducing the allowable credit, states can share directly in the federal tax savings. Denial of a full credit effectively results in double taxation of a portion of passthrough owners’ distributive shares—once at the entity level and again at the individual level—for state tax purposes. Since the individual owners bear the economic burden of the entity-level tax, the additional cost represents a nondeductible out-of-pocket expense. As long as the reduction in the state tax credit does not entirely offset the federal tax savings, however, both the states and passthrough owners benefit solely at the expense of the federal government. The ability to structure transactions in a manner that minimizes taxes without any countervailing burden nevertheless creates precisely the type of tax shelter incentives which the substantiality rules are meant to deter.
Rather than offering a full or partial credit, some states allow passthrough owners an income exclusion for profits taxed at the entity level. Beginning in 2018, Wisconsin allows a tax-option (S) corporation (or a limited liability company treated as a tax-option (S) corporation) to elect to pay tax on items that would otherwise be taxable to the shareholders. For any year in which an election is made, the owners exclude from their Wisconsin adjusted gross income their proportionate share of all items of income, gain, loss, and deduction of the tax-option (S) corporation. Because federal-state uniformity is not required, a corporation that elects S status under federal law is eligible to be taxed as a non-S corporation for state tax purposes. Allowing federal S corporations to be treated as non-S corporations for state tax purposes decouples the shareholders’ reporting of income for state and federal tax purposes. The income exclusion achieves the same result as allowing an entity-level deduction coupled with offsetting tax credits at the owner level, except that the entity-level tax represents the final tax.
Example (3): Assume that a federal S corporation with a sole owner elects under Wisconsin law to be treated as a non-S corporation for state purposes. If the S corporation earns $2 million of income and the state imposes an entity-level tax of 10%, the owner’s distributive share is reduced to $1.8 million ($1 million less $200,000 taxes paid at the entity level). No state tax credit is necessary at the owner level, however, since the $1.8 million is exempt (fully tax-paid) for state tax purposes. The non-S corporation option has the optical advantage of treating the PTE as if it were a C corporation, which is clearly not subject to the AGI concept or the section 164(b)(6) limit. Since electivity is a feature of the federal tax system, opting in to non-S status for state purposes may be difficult to challenge, even if the results allow avoidance of the limits under sections 62 and 164(b)(6).
Although sole proprietorships and single-member LLCs treated as disregarded entities (DREs) are generally ineligible to elect PTET treatment, they can take advantage of entity-level workarounds by electing S status. If an S corporation is required to pay state income tax on behalf of nonresident owners, the constructive (deemed) distribution is treated in the same manner as an actual distribution; compensatory payments to other S shareholders ensure that all shareholders continue to have identical rights to operating and liquidating distributions. When resident owners of an S corporation elect to be subject to entity-level taxes, the arrangement arguably has “the equivalent economic effect of a distribution” to electing owners. The economic equivalence argument is double edged: it would allow disproportionate distributions to nonresident S corporation shareholders to cover their share of entity-level taxes without violating the one-class-of-stock rule, but it would also justify treating entity-level taxes as giving rise to constructive distributions to electing passthrough owners who would be deemed to pay their own state income taxes.
Because it cannot make special allocations of the owners’ shares of income and expense, an S corporation is inherently less flexible than a partnership. Moreover, an S corporation generally may have no more than 100 shareholders and must satisfy the one-class-of-stock rule and other requirements. Since the vast majority of S corporations have only a single owner, however, the ownership restrictions are unlikely to have much practical effect. Failure to include S corporations in PTET regimes would “create an artificial inequity” and encourage formation of partnerships lacking substance. Nevertheless, S corporations must be careful not to violate the one-class-of-stock rule or the requirement that all items be allocated pro rata. Thus, S corporations with multiple owners are disadvantaged by comparison to partnerships because they cannot easily tailor entity-level taxes to each owner’s particular tax characteristics.
States have taken full advantage of the flexible partnership rules, coupled with the inherent electivity of PTET regimes, to construct the PTET base in the most tax-efficient manner. Electivity alleviates tensions that would otherwise arise among owners who may not all benefit equally from imposition of an entity-level tax. Such conflicts generally do not arise if all PTE members are taxable individuals and passthrough income is derived entirely within the state granting the tax credit. More complex issues arise if a PTE operates in several jurisdictions or has different types of owners. While workarounds ostensibly levy entity-level taxes, the flexible PTET base can be used to disaggregate the entity’s owners based on their individual tax characteristics. Different states define the PTET base differently, but the common goal is to impose tax on passthrough income only to the extent that each owner’s share of such income would otherwise have been subject to state income tax.
The PTET base is generally limited to income “creditable” in the state imposing the entity-level tax. The composition of the PTET base (and allowable credits) typically distinguishes between resident and nonresident shareholders. In general, states permit resident PTE members to claim credits for all of their passthrough income, while nonresident PTE members normally receive credits only against their allocable share of income “sourced” to the state. Since corporate or tax-exempt owners do not benefit from workarounds, the PTET base excludes income allocable to such owners. Certain types of partnership payments, such guaranteed payments to retired partners, may also be excluded from the PTET base.
Most states allow a credit for taxes paid to another state only for income taxes imposed on individuals (not partnerships or S corporations). Thus, a resident state credit may be denied on the ground that “the PTE, rather than the individual PTE member, actually paid the tax.” Another ground for denial of a resident credit is that the entity-level tax is not an income tax. Nevertheless, entity-level taxes are “indisputably taxes imposed on income because they are measured by essentially the same income reflected in the resident taxpayers’ personal income tax returns.” Thus, entity-level taxes paid to another state with a “similar” PTET provision will generally be creditable in the resident state. For example, New York’s PTET allows a credit to New York residents for an entity-level tax paid to another state only if the PTET in the other state is “substantially similar” to New York’s regime; the other state must impose a personal income tax substantially similar to New York’s personal income tax. The potential for double taxation arises mainly for residents of states that have not yet enacted an entity-level tax regime.
The fiction of an entity-level tax is most apparent if a PTET regime permits an owner-by-owner election, heightening the concern that, in reality, the entity-level tax is a owner-level tax. Tailoring the PTET base to include less than all owners’ distributive shares preserves the fiction of an entity-level tax, while achieving a similar result as a partner-by-partner election. Entity-level taxes that vary according to the owners’ particular tax characteristics are substantively indistinguishable from state withholding taxes levied on a nonresident owner’s distributive share. It is odd that an elective or “voluntary” tax should be respected as a tax imposed on the entity. Although state income taxes traditionally are intended primarily to raise revenue, the elective workaround regimes lack any economic substance. As an economic matter, individual owners generally should be indifferent whether tax is imposed at the individual or entity level, as long as credits are fully refundable.
Example (4): Assume that a state imposes an elective 10% income tax on partnership income and allows a 100% tax credit, but one of the partners is taxed individually at a rate of only 5% and has a distributive share of $1 million. Rather than merely reducing state tax liability on the partner’s distributive share to zero, a state tax credit of $100,000 ($1 million × 10%) produces an excess credit of $50,000 at the individual level. If the lower-taxed partner has taxable income from other sources, such as wages or investment income, the excess credits reduce state income tax on non-partnership income. Thus, excess credits can offset state income taxes on a passthrough owner’s nonbusiness income that clearly would be subject to the SALT limit. Passthrough owners’ ability to obtain an uncapped deduction for both business and nonbusiness income is inconsistent with any reasonable reading of the 2017 legislative history. By effectively imposing higher taxes on employees whose only source of income is wages, workarounds create precisely the type of discrimination that Congress perceived as objectionable in 1944.
Proponents tout workarounds as consistent with congressional intent in enacting section 164(b)(6). According to a footnote in the 2017 Conference Report, Congress expected that:
[T]axes imposed at the entity level, such as a business tax imposed on pass-through entities, that are reflected in a partner’s or S corporation shareholder’s distributive or pro-rata share of income or loss on a Schedule K-1 (or similar form), will continue to reduce such partner’s or shareholder’s distributive or pro-rata share of income as under present law.
On its face, the footnote is ambiguous, since the crucial concept of a “business tax” is undefined. Prior to the 2017 Act, most states taxed passthrough profits only at the owner level; entity-level state taxes consisted mainly of gross receipts or business activity taxes, not general income taxes. Such business taxes (including property taxes and sales taxes) were treated as bottom-line items for purposes of K-1 reporting, i.e., as non-separately stated business expenses in arriving at AGI.
Since the 2017 Act does not purport to change the existing treatment of non-income business taxes, the footnote in the legislative history is unexceptionable if read narrowly to support continued deductibility of this limited class of business taxes. A more aggressive, alternative reading of the footnote, however, is that any tax (including an income-type tax) imposed on a business entity is deductible from bottom-line income if such tax would have been deductible prior to the 2017 Act. This alternative reading would, however, seem to pose a direct conflict with the 1944 legislative history and longstanding regulations under section 62. Technically, avoiding such a conflict would require treating the passthrough entity as separate from its owners and ignoring the separate statement rules.
Of course, reference to legislative history would be unnecessary if section 164(b)(6) were clear on its face, as one commentator has suggested. Under this view, “the text of section 164(b)(6) . . . in combination with the separate statement rule . . . flatly prohibits” passthrough entities “from deducting state and local business income taxes at the entity level.” Since the conferees clearly understood that an individual engaged in a trade or business could only receive an itemized deduction for such taxes even if derived from business income, they could not have intended to sanction an entity-level deduction that would flow through as a non-separately stated item; such treatment would violate the separate statement rule because it would affect differently the liability of individual owners who could claim the standard deduction. Moreover, if the language referring to business taxes “really was meant to override the statutory text and the separate statement rule, there is no reason why it would be relegated to a footnote.” Finally, even if actually intended to override the statute, a congressional footnote in a conference report should not have any such effect.
While appealing, this argument concerning the plain meaning of section 164(b)(6) depends on reading the statutory text in conjunction with a clear separate statement rule. Application of the separate statement rule itself depends, however, on the particular provision authorizing a deduction. If section 162 authorizes an entity-level deduction for state income taxes as an ordinary business expense, the deduction may well be characterized as a bottom-line item that reduces passthrough income and never reappears in the individual owners’ hands. Prior to 2017, non-income business taxes were routinely allowed under section 162 because they were “proximately” related to a passthrough business, a lower standard than required for a sole proprietor to deduct such taxes above the line. Read in this light, the footnote may well have been inserted precisely to create uncertainty concerning the application of section 164(b)(6) to entity-level business taxes. Inserting a cryptic footnote for this purpose would also avoid highlighting the disparate treatment of passthrough owners and sole proprietors, which might be perceived as politically advantageous.
Practitioners and accounting firms interpreted the footnote as authorizing non-separately stated deductions at the entity level. One commentator expressed confidence that courts, if the issue arose, “would find the language of section 164(b)(6) to be ambiguous on the question of the treatment of entity-level taxes (whether or not incurred in connection with a trade or business) . . . .” In light of the footnote in the legislative history, it would be a short step to conclude that “the rest (including that the tax is not a separately stated item) is merely a matter of implementation of the congressional intent.” While such reasoning may appear tendentious, tax shelters often rely on similarly strained “technical” arguments.
Workaround proponents embraced the ambiguous footnote in the legislative history as superseding Congress’s earlier intent under the 1944 Act. According to one practitioner, the 1944 “legislative history appears to distinguish between property taxes, on the one hand, and income taxes on the other. However, to state the obvious, that was about three-quarters of a century ago.” Ironically, proponents instead seized upon the holding of an obscure 1958 revenue ruling that a municipal tax “imposed upon and paid by a partnership on the net profits of its business . . . is deductible in computing the taxable income of the partnership and the partners are not precluded from claiming the standard deduction.” They interpreted this ruling as authority for the broad proposition that “income and other taxes imposed upon and paid by pass-through entities are simply subtracted in calculating non-separately computed income at the entity level, and are not separately passed through.” Since “Congress, and the public, were aware of (and relied on) the Service’s longstanding interpretation [under the 1958 ruling] of how entity-level taxes are treated,” proponents maintained that entity-level taxes reduced passthrough taxable income and bypassed sections 62 and 164.
Disseminated widely within the tax bar and by business lobbying groups demanding SALT parity for passthroughs and corporations, these claims ultimately furnished the blueprint for Notice 2020-75. Subsequent to the 1958 ruling, the Service and courts refined the meaning of a generally applicable state income tax for purposes of section 62. Workaround proponents largely ignored or misread these post-1958 authorities that directly bear on the validity of Notice 2020-75. Even if Congress failed to consider explicitly the application of section 164(b)(6) to passthrough entities, the unambiguous 1944 legislative intent and implementing regulations should clearly have prevailed over the ambiguous footnote in the 2017 Conference Report.
Prior to Notice 2020-75, it was unclear whether the Service would respect entity-level workarounds. The Notice resolves the uncertainty in an extremely taxpayer-friendly manner, citing the 2017 Conference Report and the 1958 revenue ruling. According to the Notice, proposed regulations “will clarify that Specified Income Tax Payments [SITP]. . . are deductible by partnerships and S corporations in computing their non-separately stated income or loss.” The SITP must result from “a direct imposition of income tax,” regardless of “whether the imposition of and liability for the income tax is the result of an election by the entity or whether the partners or shareholders receive a partial or full deduction, exclusion, credit, or other tax benefit” that offsets their individual income taxes. The Notice provides that any deduction attributable to the SITP is not a separately stated item, under sections 702 and 1366, for purposes of determining a partner’s or an S shareholder’s individual federal tax liability. Instead, a SITP reduces the owner’s distributive share of non-separately stated items reported on a Schedule K-1 (or similar form). Specifically, a SITP “is not taken into account in applying the SALT deduction limitation to any individual who is a partner in the partnership or a shareholder of the S corporation.”
The Notice appears to bless virtually all elective (or mandatory) entity-level state income taxes as deductible for purposes of section 62. Since AGI reflects the owner’s distributive share of net income (reduced by entity-level taxes), no itemized deduction arises under section 63. Thus, partners and S shareholders are apparently not precluded from claiming a standard deduction. The Notice does not distinguish between entity-level taxes imposed on different types of income, such as ordinary business income, capital gains and section 1231 gains. Thus, it is unclear whether the Notice sanctions an above-the-line deduction only for section 162 trade-or-business expenses or extends to section 212 investment expenses. The distinction between section 162 and section 212 deductions is significant: section 162 deductions are included within the residual category of non-separately stated items but section 212 deductions generally must be separately stated.
The Notice is devoid of any analysis concerning how the passthrough provisions are intended to apply when a statute such as section 164(b)(6) does not specifically refer to the treatment of passthroughs. In other circumstances, “courts and the Treasury have construed statutes not clearly addressed to partnerships very broadly to carry out legislative intent.” The Joint Committee on Taxation General Explanation of the 2017 Act refers specifically to the 1944 legislative history, which clearly evinces an intent to treat state income taxes imposed on business income earned by individuals as nondeductible for AGI purposes. By contrast, the 2017 Conference Report is silent on this point. Entity-level workarounds frustrate the longstanding policy of establishing rough parity for AGI purposes between employees and business owners, regardless of income source. The vague reference in the footnote in the 2017 Conference Report to an undefined category of business taxes should not override the clear 1944 Congressional intent and implementing regulations.
The conduit rules generally require that any item must be taken into account separately if proper treatment of the item could be affected by the owners’ tax characteristics. In the case of partnerships, a “catch-all” requirement is found in Regulation section 1.702-1(a)(8)(ii). A similar catch-all requirement exists for S corporations. If entity-level state income taxes were stated separately, the elective workarounds would be a nullity: the SALT limit would apply to individual owners, who would be treated as having paid their respective shares of the entity-level taxes. Individual owners would be allowed only an itemized deduction under section 164(a), thereby precluding a standard deduction. The Notice conspicuously fails to explain why the separate statement rules do not apply to taxes imposed at the entity level. Indeed, the omission of any reference to Regulation section 1.702-1(a)(8)(ii) is quite remarkable given that the section 164 deduction, if separately stated, would clearly affect each owner differently based on the owner’s individual tax characteristics.
Curiously, Notice 2020-75 does not specify the statutory provision allowing a deduction for entity-level state income taxes. The Notice has been interpreted as implying that such taxes may be deductible under section 162 if they are directly or proximately related to the taxpayer’s trade or business. Nevertheless, the relevant provision should be section 164, not section 162, because partnerships and S corporations compute taxable income in the same manner as individuals. Under section 702 and 1366, income or loss characterized at the entity level retains its character when passed through to the owners. Thus, any deduction for entity-level state income taxes should be allowed only as a section 164 deduction that passes through separately to the owners. Absent separate statement treatment, a bifurcated analysis would be necessary to give effect to both the owner-level limitation under section 164(b)(6) and entity-level trade-or-business characterization under section 162.
In general, expenses qualifying under section 162 or section 212 may also qualify under another provision, such as section 164, not limited to business or investment-type activity. Taxpayers may generally elect to take these “twice-blessed deductions” under whichever classification is most advantageous. Given the legislative history of section 62, however, an entity-level deduction for state income taxes should pass through to individual owners only as an itemized deduction, subject to the section 164(b)(6) limit. This characterization preserves appropriate conduit treatment while avoiding the complexities that would arise under section 702 or section 1366 if the entity-level deduction were characterized as a section 162 trade-or-business expense.
A proposed technical amendment would clarify that “[t]he treatment of business and investment taxes remains unchanged,” notwithstanding the 2017 Act. The technical amendment suffers from the same ambiguity as the footnote in the 2017 Conference Report––namely, the failure to define business or investment taxes. Extending SALT workarounds to investment partnerships is likely to prove particularly controversial because wealthy passthrough owners earn a disproportionate share of passthrough investment income. Sophisticated individual investors could contribute securities to a partnership to take advantage of entity-level taxation. If state income taxes are subtracted in determining partnership taxable income, the owner-level income exclusion also reduces self-employment tax and net investment income tax.
When the Service issued Notice 2020-75, it promised to provide additional guidance. To withstand challenge as arbitrary and capricious, any future regulations would need to radically revise the Notice’s framework and reasoning. It remains unclear when, or whether, the Service will issue further guidance. Given scant resources and the 2025 sunset of the SALT provisions, the Service may consider that its attention should be focused on more pressing issues. The Service may also consider that crafting regulations for public comment is not worthwhile in light of possible legislative changes to the SALT cap. In the absence of regulations, states have continued to experiment with entity-level workarounds, draining significant federal tax revenue. Even if future legislation were to significantly modify or repeal the SALT limit, the Service should disavow Notice 2020-75 to reassure taxpayers that the statute and regulations are being applied in a uniform and fair manner.
Notice 2020-75 is plainly inconsistent with Congress’s reliance on the AGI concept to provide rough parity between employees and business owners. After entity-level taxes are subtracted, a passthrough owner reporting income of $1 million is clearly better off than an individual employee earning $1 million of wages. The passthrough owner’s AGI reflects the deduction for state income taxes, while the wage earner is limited to a capped itemized deduction. Notice 2020-75 conspicuously fails to explain the rationale for the business/nonbusiness distinction or the meaning of “state taxes on net income” as clarified in post-1958 guidance and cases. Apart from the 1958 ruling, workaround proponents’ only support for an egregious tax shelter is an ambiguous footnote in the 2017 Conference Report.
Almost immediately after enactment of the 1944 legislation, the Service was forced to reconsider earlier guidance concerning deductibility of state income taxes in light of the new AGI concept. In 1945, the Service reexamined an earlier ruling that allowed a deduction for a Philadelphia income tax imposed on “salaries, wages, and net profits of unincorporated business enterprises.” Enacted in 1933, the Philadelphia income tax represented a response to the fiscal emergency arising from the Great Depression. The flat-rate income tax applied broadly and produced significant revenues at relatively low rates. Prior to the 1944 Act, the Philadelphia tax was deductible in computing taxable income, without any intermediate AGI filter. After introduction of the AGI concept, however, both employees and sole proprietors were relegated to itemized deductions for the tax, preserving equality of treatment. Income tax imposed on salaries and wages was nondeductible for AGI purposes because it was attributable to a trade or business “which consists of the ‘performance of services as an employee.’” Similarly, income tax imposed on net profits of businesses or professions was nondeductible for AGI purposes because “it does not represent an expense directly incurred in the carrying on of a business or profession.” In 1945, the Service also determined that a New York state emergency tax on net incomes of unincorporated businesses was not deductible in computing AGI.
In 1954, the Service considered a tax imposed on all compensation earned and net profits of all businesses conducted within the city of Louisville, Kentucky. The tax was held to be deductible from partnership taxable income and could be deducted by a sole proprietor in arriving at AGI, but employees were limited to an itemized deduction for any tax imposed on salaries and wages. Although the ruling refers to the tax as an “income tax,” by its terms the tax was a license fee for the privilege of engaging in certain activities. If the tax was really an income tax, then a sole proprietor should clearly have been relegated to an itemized deduction.
On several occasions, the Service struggled to determine whether section 62 barred an above-the-line deduction for an Indiana gross income tax on business receipts and personal service income. Enacted in the same year as the Philadelphia tax, the Indiana tax was also a depression-era emergency measure. The gross income tax base did not distinguish between the type of taxpayer or the form of business organization; nor was any allowance made for expenses incurred in generating gross receipts or gross income. The label attached to the Indiana tax suggested superficially that it was an income tax, but it was actually a gross receipts or “turnover tax . . . misleadingly called a gross income tax.” Indeed, the tax has been described as a “curious hybrid” that belonged to the category of general sales tax but resembled an income tax as applied to wage and salary income.
Since gross income and net income are roughly equal for most individuals who have only wages and salaries, the gross receipts tax was similar to a flat-rate income tax without any deductions at the personal level. As applied to businesses, however, the portion of the gross receipts tax shifted to consumers functioned as a hidden sales tax. While retail sales taxes are intended to apply only to final sales to customers, gross receipts taxes are imposed on all business transactions (including intermediate business-to-business transactions). The inefficient “pyramiding” of such taxes can result in quite high effective rates on net income because multiple turnovers produce multiple layers of tax. While other Depression-era gross receipts taxes were clearly business privilege taxes, the Indiana tax was the “only one which comprehensively tax[ed] personal receipts.”
Although clearly not a tax on net income or net business profits, the hybrid Indiana tax raised a troublesome problem of classification for purposes of section 62. In 1945, the Service held that the gross income tax levied on partnership income was not deductible for purposes of section 62 “whether such tax [was] paid by the partnership or, in their aliquot shares, by the partners individually.” To the extent that each partner’s share of partnership income was received “free of tax liability,” there might be “a substitution of the tax-paying entity . . . [but such substitution] did not operate to destroy the ultimate individual liability for the tax or the character of the tax as a State income tax.” For purposes of determining AGI, the disallowed partnership deduction should instead be “allocated to the individual partners in a manner similar to the allocation of partnership charitable contributions.” Each partner would have an itemized deduction for an aliquot share of the gross income tax and would not be allowed to claim a standard deduction.
In two subsequent rulings, however, the Service revisited the Indiana gross income tax and reversed course. I.T. 3766 jettisoned the notion of treating state tax paid at the partnership level analogously to the charitable deduction. Since a partnership generally determines its income in the same manner as an individual with certain exceptions, I.T. 3766 found that such taxes should be deductible in computing the partnership’s net income if individuals would be allowed a deduction under section 164. Nevertheless, a sole proprietor was not allowed to deduct the same tax, in computing AGI, because it was “not a direct consequence of, nor ‘directly attributable’ to, doing business.” Subsequently, I.T. 3829 reversed that portion of I.T. 3766’s holding, concluding that a sole proprietor could claim an above-the-line deduction because the tax on gross income was “directly attributable to a trade or business” for purposes of section 62. The net result was to harmonize the treatment of partners and sole proprietors conducting a trade or business: if individual partners could deduct the gross income tax under section 164, it reduced the partnership’s taxable income, providing the equivalent of an above-the-line deduction. Likewise, a sole proprietor could deduct the gross income tax in computing AGI, preserving tax parity.
For purposes of section 62, both the Treasury and the courts continue to distinguish between state taxes on “net” and “gross” income. While state taxes on “net” income are not “directly related” for purposes of section 62 even though income is derived from a business, state taxes on gross income “attributable to” a trade or business may be deductible above the line. Because owners could deduct gross income taxes above the line if they conducted the business individually, sole proprietors and partners are treated alike for purposes of section 62; they receive an above-the-line deduction (or its equivalent) for gross income taxes paid. The equivalence does not hold, however, if state income taxes levied on a sole proprietor are nondeductible under section 62, while the identical tax imposed on a passthrough entity is treated as a non-separately stated deduction that reduces the owners’ distributive shares.
Against this backdrop, Rev. Rul. 58-25 considered the deductibility of a Cincinnati “earned income” tax imposed on “net profits of all unincorporated businesses.” An unpublished draft of the 1958 ruling would have treated the earned income tax as deductible by a sole proprietor for AGI purposes because it was “attributable” to the proprietor’s trade or business. By contrast, General Counsel Memorandum (GCM) 28947 concluded that the earned income tax constituted an income tax and the proposed ruling was therefore inconsistent with the Service’s “consistently adhered to view that a general income tax is not deductible” under section 62.
The published 1958 ruling adhered closely to the reasoning of GCM 28947. It distinguished the 1945 rulings involving Indiana’s gross income tax, since the earned income tax was imposed on net profits (rather than gross receipts) of unincorporated businesses. Because the earned income tax was an income tax within the meaning of Temporary Regulation section 1.62-1T(d), it was deductible by a sole proprietor only as an itemized deduction. The 1958 ruling cited I.T. 3766 and I.T. 3829 for the proposition that section 62 does not apply to taxes imposed directly on a partnership, since the 1939 Code contained no comparable provision for computing a partnership’s adjusted gross income. Thus, the earned income tax could be subtracted from partnership taxable income, even though individual partners could not have deducted the tax in arriving at AGI, and the individual partners could claim a standard deduction. Although Treasury regulations incorporating the separate statement requirement had been issued in 1956, the 1958 ruling assumed, without discussion, that the deduction was not a separately stated item.
Revenue Ruling 58-25 created a new disparity between partners and sole proprietors. The ruling could easily have avoided this inequity by requiring the earned income tax to be separately stated; in that case, partners would have been barred under section 62 from deducting their share of the separately stated items, just as if they had conducted the partnership’s business in their individual capacities. Since prior rulings were at pains to harmonize the treatment of sole proprietors and partners, it seems odd that the 1958 ruling should have casually introduced such a disparity without further analysis. Under the 1939 Code, the aggregate view of partnerships and partners generally prevailed. Thus, it seems unlikely that Congress in 1944 would have viewed partners and sole proprietors as differently situated. Although the 1954 Code treated partnerships as entities for certain purposes, mainly in the interest of promoting simplicity, the aggregate view continued to treat partners as conducting the partnership’s business individually. Indeed, the disparate treatment of partners and sole proprietors under the 1958 ruling demonstrates the importance of the separate statement requirement. Without separate statement, partners and sole proprietors were treated unequally for purposes of determining AGI.
Notice 2020-75 relies on the 1958 ruling but conspicuously fails to mention the Service’s later guidance concerning the meaning of a state tax on net income. In Rev. Rul. 81-288, the Service considered whether, in determining AGI, a sole proprietor could deduct the New Hampshire Business Profits Tax imposed on “taxable business profits” of every business organization, including sole proprietorships. Based on the legislative history of section 62, the ruling concluded that Congress intended that “state income taxes, imposed generally, would not be deductible under section 62 of the Code merely because the net income arose from a business, but that taxes of any kind that are imposed only on business activity, or business property, or business income, would be deductible.” Accordingly, the reference in Temporary Regulation section 1.62-1T(d) to state taxes on net income “pertains to state income taxes of general application, such as those imposed on salaries, investment income, and other forms of income in addition to business income.” By contrast, the New Hampshire Business Profits Tax was a “tax only on the privilege of entering into a trade or business in that state,” measured by the “net profits from the trade or business,” after deducting reasonable compensation for the proprietor’s services. Because the business profits tax was “not a tax of general application for purposes of section 62,” it fell outside the meaning of a state tax on net income. As a result, a sole proprietor could deduct the non-income tax in determining AGI.
In a separate GCM, the Service discussed the rationale underlying Rev. Rul. 81-288. According to the GCM, the business profits tax “exists in a gray middle ground between an income and a business tax.” Although the tax “appears to be applicable only to business and directly related to the conduct of a business,” it also “appears to be within the literal wording” of Temporary Regulation section 1.62-1T(d). To resolve this uncertainty, the Service looked to the 1944 legislative history, the purpose of section 62, and the meaning of state income taxes and state taxes on net income. The GCM characterized the 1944 legislative history as stating, “in essence, that it would be inequitable to allow a deduction under section 62 to proprietor/taxpayers for expenses such as ‘state income taxes incurred on business profits,’ which are not direct business expenses but rather . . . personal expenses, while disallowing such deduction to other taxpayers who are subject to the same tax.”
Since the regulations under section 62 incorporated the 1944 congressional intent, it was necessary to determine whether the business profits tax fell within their intended scope. The reference to “state taxes on net income” under Temporary Regulation section 1.62-1T(d) refers back to “state income taxes” in the 1944 legislative history. Congress intended to use the term “income tax” in accordance with its generally accepted meaning as a “tax levied on all (or most) sources of income of a person or an entity.” Even though income (net or gross) is used as the measurement of taxation, taxes of “limited” as opposed to “general” applicability are not income taxes within the meaning of section 62. In determining “whether a tax is an ‘income tax’ for purposes of section 62 . . . the purpose and application of the tax must be determined.”
In light of the 1944 legislative history, the distinction between taxes of limited and general application seems sensible. Congress intended to deny a sole proprietor a deduction in computing AGI for “a state income tax on profits that he or she receives from a business when an employee [who] receives an equivalent of compensation from the same work could not deduct that same tax in computing the employee’s adjusted gross income.” Under this analysis, the state’s business profits tax “is not a tax of general application, nor is it imposed in lieu of an income tax.” Rather, the New Hampshire Business Profits Tax is “a tax on business activities, measured by net profits, that in no way purports to be an income tax.” Since the tax could be “incurred only directly in connection with the conduct of a trade or business,” it could not give rise to the type of inequity that motivated Congress to deny an above-the-line deduction to a sole proprietor. For purposes of section 62, “the term ‘state taxes on net income’ may be read to refer to income taxes of a general nature, applicable to most or all income, computed on a net basis.”
Courts have drawn a similar distinction between generally applicable state income taxes and non-income business taxes. The restrictive definition of a state income tax, under section 62, comports with Congress’s intent to treat employees and owners alike for AGI purposes. A non-income tax levied only on trade-or-business activities may indirectly affect an employee’s wages, but the employee is not discriminated against merely because a sole proprietor can deduct the business tax for AGI purposes. While most “business” taxes are non-income taxes within the meaning of section 62, focusing on Congress’s intent in creating the AGI concept serves to isolate those business taxes that cross over the income tax line. Thus, the reference to business taxes in the 2017 legislative history should be read as referring only to those business taxes, like the New Hampshire Business Profits Tax, that are not generally applicable state income taxes (or substitutes for such income taxes).
Apart from the 1958 ruling, workaround proponents pointed to Rev. Rul. 71-278 to bolster their assertion that all entity-level taxes were deductible above the line. In fact, Rev. Rul. 71-278 merely updates and restates the conclusions from the 1940s rulings concerning deductibility of the Indiana gross income tax paid by a partnership or sole proprietor. As Rev. Rul. 71-278 notes, if the partnership paid a tax upon receipt of gross income, such gross income was exempt in the partners’ hands when received. For federal tax purposes, the gross income tax paid by a partnership was deductible from the partnership’s income under section 164, since partnership income is computed “in the same manner and on the same basis as in the case of an individual.” Although the partners could not deduct the taxes paid by the partnership, they were not precluded from claiming a standard deduction. In a companion ruling, the Service held that the identical gross income tax paid by a sole proprietor is “directly attributable to a trade or business” conducted by the taxpayer and thus deductible in computing AGI.
The distinguishing feature of Rev. Rul. 71-278 is that it involves a gross income tax, not a net income tax of general applicability. Thus, the ruling hardly supports the claim of workaround proponents that separate statement is not required for a business income tax. While a gross income tax imposed at the entity level would appear to generate an above-the-line deduction, the reason is that such a tax has never been considered an income tax within the meaning of section 62. A gross receipts or gross income tax is essentially a tax on business activity that bears no relationship to business profits. Since a gross income tax “is not a tax on real property, personal property, income, or general sales at retail,” such a tax would also appear to avoid the section 164(b)(6) limit. Workaround proponents would have been on firmer ground if states had imposed a gross income tax at the entity level. As a practical matter, however, a gross income tax is unlikely to function well as a substitute for a generally applicable tax on net income.
While the Notice inexplicably fails to refer to Rev. Rul. 81-288, entity-level passthrough taxes are clearly state income taxes of general applicability within the meaning of section 62. Indeed, such taxes are creditable for state tax purposes precisely because they are nearly perfect substitutes for taxes on income that would otherwise be reflected on the owners’ personal tax returns. The PTET base is carefully constructed to include only income that would otherwise be taxable at the individual level. Because the PTET base takes into account the owners’ individual tax characteristics, the notion of an entity-level tax is illusory. The different mechanisms for relieving owner-level tax—whether a full or partial credit or income exclusion—ensure that the entity-level tax is simply a device by which states and passthrough owners share the benefits of reducing federal taxes. If the Notice had considered Rev. Rul. 81-288, the Service would have been forced to conclude that PTETs effect a “substitution” of the taxpaying entity but leave unaffected the ultimate economic burden of the tax or its character as a generally applicable state income tax. Assume that a state imposes general income taxes on income from all sources but excludes business income earned through passthrough entities, which are instead subject to a gross income tax less reasonable deductions. Substantively, the business tax should be considered part of the general state income tax and should be subject to the same limitations applicable to state taxes on net income. Indeed, aggregate treatment of passthrough entities requires disallowing the entity-level deduction and instead treating the entity’s tax payment as a deemed distribution to owners to pay their individual taxes, subject to sections 62 and 164(b)(6).
One commentator has characterized as “thoroughly unconvincing” the stated rationale under the section 62 regulations for denying an above-the-line deduction for business income taxes: “How could any tax be more directly related to a trade or business than a tax on the income that it generates?” But the rationale for such treatment clearly traces back to Congress’s codification of the AGI concept in 1944 in an attempt to create rough parity between taxpayers whose income was derived from different sources. Because the AGI concept was intended to approximate taxing net income in an economic sense, an above-the-line deduction was disallowed for state income taxes; in an accounting sense, such taxes were not considered a cost of earning income. As a practical matter, entity-level computation of net income from business and investment activity represents merely an administratively convenient method of determining the owners’ taxpaying capacity. Allowing passthrough owners the equivalent of an above-the-line deduction for entity-level state income taxes defeats the intent of the 1944 legislation to impose a uniform distribution of the tax burden, regardless of the source of income.
Regardless of whether Congress retains the SALT cap, Notice 2020-75 should be rescinded. The Notice is not only unpersuasive in its reasoning and misguided in its policy, but it also undermines confidence in fair administration of the tax laws. Just as noncorporate businesses demanded a lower tax rate to compensate for the 2017 Act’s reduction in the corporate tax rate, business lobbying groups promoted SALT parity as a means of justifying full deductibility of state income taxes by passthrough owners. This rhetorical invocation of parity conflates fairness between different types of business entities with equitable distribution of the tax burden between business owners and nonbusiness taxpayers. Predictably, states responded to business demands by introducing entity-level taxes that distort the passthrough nature of partnerships and S corporations and exacerbate nonuniformity in state business taxation. Ironically, the state PTET experiment may strengthen the argument for entity-level federal taxation of passthrough businesses as a way to reduce the inordinate complexity exploited by wealthy owners.
