What The New SALT Workaround Legislation Means for Taxpayers

On August 27, Illinois Governor J.B. Pritzker signed into law a bill that will provide owners of partnerships or S corporations with a workaround to the federal $10,000 state and local tax (SALT) deduction cap applicable to individual taxpayers.

This new law will provide a major break to Illinois taxpayers who were otherwise unable to benefit from state tax payments on their pass-through income from their businesses.

What is SALT, and how have SALT deductions changed?
Before the 2018 tax year, an individual taxpayer could deduct an unlimited amount of state and local tax (SALT) payments for federal income tax purposes. As a result of the Tax Cuts and Jobs Act of 2017, beginning with the 2018 tax year, an individual can deduct no more than $10,000 of such taxes paid. Many states have devised a workaround involving to this limitation by allowing the pass-through entities (PTEs) to deduct the tax at the business level.

How does the new law provide a workaround?
In Illinois, the law allows businesses to elect to pay a 4.95% entity-level tax that is creditable against the owners’ personal Illinois taxes. A PTE must make an annual irrevocable election (PTE election) to take advantage of this workaround. The electing pass-through entity pays a 4.95% Illinois income tax (PTE tax) on its federal taxable income, with certain modifications, which is the same tax rate applicable to Illinois individual taxpayers.

For federal tax purposes, the PTE deducts the Illinois state tax when calculating taxable income, thereby reducing each partner’s or shareholder’s share of the taxable income. A PTE is not subject to the SALT deduction cap, so it deducts the Illinois tax in full. (An individual partner or shareholder does not take into account the state tax that the PTE pays when applying the SALT deduction limitation to which the individual is subject.)

How is this new legislation an advantage?
For Illinois tax purposes, each partner or shareholder gets a credit for their respective allocable shares of the Illinois taxes paid by the PTE. This credit is a dollar-for-dollar reduction of the individual owner’s personal Illinois income taxes.

To illustrate, let’s consider the following example. “AB Partnership” is a company held by two equal partners who opt to make their PTE election for calendar year 2021. The company has $1 million of federal taxable income before deducting the PTE tax, which comes to $49,500. Upon payment, each partner receives a $24,750 credit against their Illinois individual income tax (4.95% times $500,000, each partner’s distributive share of AB’s Illinois taxable income), which is equal to each partner’s Illinois individual income tax liability. Further, AB’s federal taxable income is reduced by $49,500 in the year the $49,500 PTE tax is paid, which in turn will also reduce each partner’s federal taxable income by $24,750.

Who should not consider this workaround?
The PTE election is not designed to benefit all taxpayers who qualify. For example, it may not be advantageous if the PTE owners are non-residents of Illinois. In such cases, most states allow individuals a credit for personal taxes paid to another state to avoid double taxation. With the PTE election, the tax shifts from a personal tax to an entity-level tax. As such, the individual owner taxpayers lose the credit in their home state for taxes paid to Illinois.

Additionally, the PTE election may not make sense for an entity with otherwise allowable Illinois income tax credits that flow through to the individual owners. If the credits are non-refundable and the owners have no Illinois tax liability because of the PTE credit, the credits are rendered useless.

What else do I need to know?
An electing PTE is required to pay quarterly estimated taxes for the taxable year for which it makes the election if the entity can reasonably expect that the estimated tax will exceed $500. However, the Illinois Department of Revenue (IDOR) will not assess any late payment penalties to taxpayers who make their PTE election for tax years ending before December 31, 2022.

For additional information regarding this new legislation, as well as analysis of its application to your entity’s and your personal income tax situation, please do not hesitate to contact a Weiss tax professional.