Tax Law

How Law Firm Owners Can Legally Get Around The $10,000 State And Local Tax Deduction Limitation

Law firms should check their state tax laws and consult with their tax professionals to see if the IRS’s Notice 2020-75 allows them a workaround for the unpopular state and local tax deduction limitation.

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When the Tax Cuts and Jobs Act was passed in 2017, one of the more controversial provisions was the $10,000 limitation of the state and local tax deduction. For those who paid high state income and sales taxes, this resulted in a tax increase because the limitation increased their taxable income. It was criticized as a punishment against Democrat-leaning states that tended to have higher state income taxes and higher costs of living.

Some state legislatures tried to circumvent the provision, first by designating the payment of state taxes equivalent to a charitable contribution. But the Treasury Department under President Donald Trump issued a ruling disallowing the workaround.

Then they considered another approach: imposing an income tax at the business level which would be equivalent to the owner’s personal state income tax. The tax paid by the business could then be deducted as a business expense thus getting around the $10,000 state and local tax limitation. Would the IRS allow this? It was an open question but likely to be denied while Trump was in office.

Fast forward to the 2020 elections. For the next few days after election day, the world was waiting for the official results while Trump filed multiple lawsuits in key states alleging voting fraud. Most of these lawsuits were thrown out soon after they were filed and, on November 7, most of the major media outlets called the election for Joe Biden.

On November 9, the IRS issued Notice 2020-75 which revisited the state and local deduction workaround mentioned earlier. It said that state and local income taxes paid by a partnership or S corporation on its income are allowed as a deduction by the partnership or S corporation and therefore are not subject to the state and local tax deduction limitation for partners and shareholders who itemize deductions. However, there is a significant limitation. The deduction is only allowed to pass-through entities which are S corporations and partnerships. Entities filing as C corporations and Schedule C sole proprietorships are not allowed to take this deduction.

In response, several states have passed laws taking advantage of the IRS notice. While the details for each state vary, they generally allow an entity to pay an employee’s state income tax and take an entity-level deduction and pass through the reduced taxable income to the owner or owners of the entity. The state will then impose a credit, deduction, or income exclusion on the personal tax return in order to avoid a second income tax at the personal level.

For example, last July, California passed AB 150. This allows certain pass-through entities to annually elect to pay an elective tax in the amount of 9.3% of the pro rata share or distributive share of the entity’s partners, shareholders, or members. The partners, shareholders, and members then receive a tax credit equal to that amount. The law is effective for taxable years beginning on or after January 1, 2021, and before January 1, 2026. However, if the tax credit exceeds state income tax due, the taxpayer does not get a refund. Instead, the excess is carried forward for up to five years and any credit remaining is lost.

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Large companies may be reluctant to opt into paying state income taxes at the entity level because it might be too burdensome. However, this can be easily adapted by smaller businesses with few owners, which includes law firms.

But Notice 2020-75 isn’t perfect and some people will be left out. This ruling favors business owners over W-2 employees because the laws do not allow them to take a similar income tax deduction and credit.

Another problem is that it does not provide a similar workaround for businesses operating as sole proprietorships. But there can be a workaround to this too. For example, sole proprietorships can form S corporations although the annual fees and operational expenses could offset the tax savings. Businesses run by two spouses can choose to file as a partnership.

Lastly, this benefit might not help the people who need it most. People with lower income will probably get a greater benefit by taking the standard deduction as they generally pay little to no state income tax. Middle class business owners will have to do some calculations to determine whether this workaround will work for them. This usually means preparing a hypothetical second tax return or paying a professional to do a comparison. Those that are on the fence will have to be careful on spending their money in order to qualify for the benefit.

Because of the above, as a policy matter, this tends to favor the wealthy who are more likely to take itemized deductions and take advantage of the workaround. Not only that, since the state tax deduction is taken at the entity level instead of as an itemized deduction, they can also avoid or minimize the federal alternative minimum tax which is usually calculated by adding back most itemized deductions to taxable income. This goes against the general Democrat policy of increasing taxes on the wealthy. Or at least limiting their tax deductions.

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The IRS’s Notice 2020-75 allows a workaround for the unpopular state and local tax deduction limitation. Law firms should check their state tax laws and consult with their tax professional to see if a workaround law exists and whether it will work for them.

But workarounds are not perfect. The people who need them most might not qualify or will have to spend time and money to determine whether they will benefit. Hopefully there will be more government-approved workarounds that will address this problem.

Or maybe the government should just repeal the limitation altogether while they still can.

Steven Chung is a tax attorney in Los Angeles, California. He helps people with basic tax planning and resolve tax disputes. He is also sympathetic to people with large student loans. He can be reached via email at sachimalbe@excite.com. Or you can connect with him on Twitter (@stevenchung) and connect with him on LinkedIn.

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