Many restaurant owners could be uniquely positioned to slice thousands of dollars off their federal tax bill due to the recent proliferation of state-level elective pass-through entity taxes. If your restaurant is a pass-through entity operating as a partnership, LLC taxed as a partnership, or an S corporation, there may be significant tax savings opportunities based on your geographic footprint.
Background
In 2017 as part of the Tax Cuts and Job Act, Congress capped the individual deduction for state and local taxes at $10,000 (the “SALT Cap”).[1] This SALT Cap includes limiting state taxes paid by restaurant owners operating their business as a pass-through entity. For many people, this was a significant limitation and a tax hike. Various groups unsuccessfully challenged the SALT Cap in court, but a partial solution emerged for some business owners, and the IRS blessed it. In IRS Notice 2020-75, the IRS clarified that taxes paid by a partnership or S corporation to satisfy a state or local income tax imposed on the partnership or S corporation are deductible to the partnership or S corporation and not subject to the SALT Cap. This is true even if the tax due is the result of an election by the partnership or S corporation, and regardless of whether the owners receive a state deduction or credit for their share of the tax paid.
State Elections
About thirty states have now enacted an elective pass-through entity tax (often referred to as a “SALT Cap Workaround”). Every state is a little different, but here is a simplified illustration of how a typical election might help owners save taxes:
Suppose “LLC” taxed as a partnership operates a chain of popular fast-casual restaurants located in State A. “LLC” has two individual members who reside in State A and share the profits of “LLC” 50/50. State A’s income tax rate is 4.0% but State A also has a SALT Cap Workaround. “LLC” has profit of $2,000,000.
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- If “LLC” does not make the election then each member will pay $40,000 of State A income tax ($1,000,000 x 4.0%) but will be limited to a $10,000 itemized deduction for state and local taxes on the member’s federal tax return.
. - Alternatively, if “LLC” makes the election, then “LLC” will pay $80,000 of State A tax. Those taxes are fully deductible to “LLC” on its federal return, and those allocated deductions will flow through to each member as part of the Schedule K-1 income reported to each member. Each member will effectively get a $40,000 deduction rather than a $10,000 deduction that is limited by the SALT Cap. At the top marginal tax rate of 37%, each member will save $11,100 in federal taxes ($30,000 x 37%). State A requires each member to reverse the $40,000 tax deduction but allows a credit for those taxes, resulting in a net neutral tax effect for State A income tax.
- If “LLC” does not make the election then each member will pay $40,000 of State A income tax ($1,000,000 x 4.0%) but will be limited to a $10,000 itemized deduction for state and local taxes on the member’s federal tax return.
Does an election work for my business?
In a simple scenario like the one above, the members would seemingly have an easy decision to make. However, many situations are not so simple and every state’s SALT Cap Workaround has its nuances. Not surprisingly, the analysis can get complex in a hurry.
There are many things to consider before making an election in any state, including:
- What type of entities and owners are eligible
- When the election must be made
- Who must approve the election
- How the tax base is calculated and apportioned
- Cash flow impacts (e.g., estimated payment requirements, whether the state credit is refundable to the owners)
- Tax year to which payments will be deductible based on accounting methods and when the payment is made
- Costs of compliance (e.g., additional tax returns, accounting fees, possible legal fees)
For multistate businesses, and businesses with owners who live in different states, it is especially important to review each state’s SALT Cap Workaround to see whether it would benefit the owners to make an election. When analyzing an election in a state that is not the owners’ state of residence, it is important to be mindful of how the residence state will treat an election in another state. There are situations where an owner’s federal tax benefit from an election in one state could be significantly offset by adverse tax consequences in the owner’s home state.
It bears repeating that each state’s SALT Cap Workaround is a little different. If a business has the right facts and otherwise qualifies to elect into a SALT Cap Workaround, the federal tax savings can be significant. Careful, thoughtful, and timely analysis is key to planning for these savings. If you have any questions, please reach out to your GBQ tax team.
Article written by:
Kaz Unalan, CPA, CEPA
Director, Tax & Business Advisory Services
John Petzinger
Manager, State & Local Tax Services
[1] This is a temporary provision set to expire after 2025. Time will tell whether Congress will let it expire, extend it, raise the cap, or something else.
