July 2022 - RVG & Company

Currently, twenty-nine states and one city have enacted State and Local Tax (SALT) Cap Workaround Laws (SCWLs) that enable the owners of pass-through entities (PTEs), such as Partnerships, S-Corporations, and LLCs, to minimize their federal tax liability by circumventing the $10,000 cap on state and local tax deductions (SALT Cap) for individuals.

The SALT Cap was part of the 2017 Tax Cut and Jobs Act (TCJA) that is effective for tax years 2018 through 2025. It primarily affects individuals who itemized their deductions and pay significant state taxes. The SALT Cap impacts high-income individuals that reside or do business in states that impose high taxes, such as California, Connecticut, and New York. Recently, states with lower rates of tax are also adopting SCWLs to benefit their high-income residents.

Even taxpayers that reside in states that have no income tax can recognize the federal tax benefit from the SCWLs if their business operates in states that impose income taxes.

The SCWLs reduce the SALT Cap’s effect on owners of PTEs. However, individuals earning wages generally cannot take advantage of the SCWLs. In short, this strategy converts a business owner’s personal state income taxes, which are attributable to the PTE, into deductible business taxes that escape the $10,000 cap on state and local tax deductions. The SCWLs, provide PTE businesses the same state tax deduction that C corporations have.

Federal Tax Impact of SCWL

In response to the Tax Cut and Jobs Act (TCJA) SALT Cap, several states adopted an elective PTE level tax as a workaround to provide a federal tax benefit to their residents without costing the states any tax revenue.

The benefit of the PTE paying the tax is that owners can re-characterize a non-deductible state income tax expense to a deductible tax expense for federal tax purposes. If these taxes were attributed to the owner, the SALT limitation would apply if the owner’s itemized state tax deductions for state taxes exceeded $10,000.

It should be noted that the IRS has approved the enactment of the SALT Cap Workarounds passed by the states. In November of 2020, the IRS announced in Notice 2020-75, that it will issue proposed regulations that confirm that the entity-level state taxes imposed on PTEs are not subject to the $10,000 SALT Cap limit to their owners.

Federal Tax Impact Without SCWL

Without the enactment of SCWLs, taxes paid by PTEs are treated as paid on behalf of their owners (partners and shareholders) and must be separately stated on their individual tax returns. Internal Revenue Code §164(b)(2) and §1366(a)(1), respectively require that a partner or shareholder of an S corporation take into account separately their pro-rata share of taxes paid by the partnership or S corporation that is included in their share of K-1 income. The deductibility of the tax is determined at the partner or shareholder level. These taxes include nonresident tax withholding and composite tax payments.

State Tax Impact

While each state’s SCWL may vary slightly, they generally permit the owners of the PTE to take a credit for the taxes paid by the entity to avoid double taxation. However, PTE owners that reside in states that did not enact a SALT Cap Workaround, may not receive a credit for the taxes paid by the PTE in another state. As a result, there may be a disparity among the owners of a PTE with respect to receiving a state benefit.

Conclusion

The potential benefit of the SALT Cap Workaround election must be evaluated on a case-by-case basis. There is an added complexity to this analysis where the PTE conducts business in multiple states and has owners that reside in different states as well. Since only twenty-eight states (see below for a list*) have enacted SCWLs, it is possible that there will be a difference between the overall benefit to each of the owners based on whether their state allows them a credit or deduction for taxes paid by the PTE. As noted above, each state may have nuances to the SCWL that must be considered. For example, Wisconsin imposes a higher rate of tax on a PTE than an individual.

RVG & Company

If you would like to discuss the potential impact that the SALT Cap Work Around may have on your business, please call RVG & Company at 954.233.1767.

*Jurisdictions that have adopted SCWLs: AL, AK, AZ, CA, CO, CT, GA, ID, IL, KA, LA, MD, MA, MI, MN,MO, MS, NJ, NY, New York City, NM, NC, OH, OK, OR, SC, RI, UT, VA, and WI.

Last month the U.S. Supreme Court agreed to hear the appeal of the Bittner case where the taxpayer is contesting the IRS’s method for computing the FBAR penalty. Under the Bank Secrecy Act of 1970 (BSA), US taxpayers must report their ownership in foreign financial accounts if the combined value of those accounts exceed $10,000. Taxpayers must annually report this ownership on Form 114 Report of Foreign Bank and Financial Accounts (FBAR). Under federal law, the non-willful failure to report an interest in a foreign account is $10,000.

Overview

Currently, the IRS assesses penalties for each financial account that is omitted from an FBAR. That means, if a taxpayer fails to report 10 foreign financial accounts on a single FBAR filing, the IRS will impose $100,000 of penalties ($10,000 X 10 unreported accounts).

During 2021, the Court of Appeals issued two conflicting decisions regarding the calculation of the penalty. One decision in the Fifth Circuit followed the IRS’s formula (noted above). Another decision in the Ninth Circuit held in favor of the taxpayer where the penalty was computed on a per form basis resulting in a $10,000 maximum penalty – for the omission of 13 foreign accounts. The US Supreme Court has agreed to resolve this inconsistent application of the FBAR penalty under the BSA.

Bittner Decision in the Court of Appeals 5th Circuit

The taxpayer in Bittner is appealing to the Supreme Court because the Court of Appeals for the 5th Circuit upheld the IRS’s computation of the non-willful FBAR penalty. Upon audit, the IRS assessed penalties for years 2007 through 2011 totaling $2.72 million on 272 accounts that were not reported on FBARs. The Court ruled that the non-willful FBAR penalty applied to each unreported foreign account, and not on a per annual FBAR form basis. This decision was issued in November of 2021. If the penalty was applied on a per form basis for each year, the taxpayer would have been subject to $50,000 of penalties as opposed to the $2.72 million calculated by the IRS.

Boyd Decision in the Court of Appeals 9th Circuit

In March of 2021, the Court of Appeals for the 9th Circuit held in favor of the taxpayer and determined that the non-willful FBAR penalty should be calculated on an annual form basis rather than per omitted account. In Boyd, the taxpayer had an ownership interest in 13 financial accounts in the United Kingdom that were subject to FBAR reporting.

By way of background, for the 2010 tax year, the taxpayer failed to report income and file an FBAR related to their foreign financial accounts. In 2012, the taxpayer amended their 2010 tax return, under the IRS’s Voluntary Disclosure Program, to report the income and file the FBAR for the foreign accounts. Upon audit, the IRS imposed the $10,000 FBAR penalty for each of the 13 foreign accounts.

The 9th Circuit disagreed with the IRS’s penalty computation. The Court stated that the BSA does not authorize the IRS to issue a separate penalty for each account that should have been listed on the FBAR. Thus, the Court held that the non-willful omission of multiple accounts from an FBAR to be a single violation subject to a maximum penalty of $10,000.

RVG Observation

Since the decisions in Bittner and Boyd conflict, the Supreme Court’s decision to grant certiorari in Bittner should bring clarity to the application of the non-willful FBAR penalty. This uniform approach is necessary due to the rapid growth of the global economy. The case will be heard by the Court in the fall of 2022.

If you would like to discuss the potential impact that the FBAR rules may have on you, please call RVG & Company at 954.233.1767 to speak with on of our experts in this area.

Month: July 2022

Business Owners of Pass-Through Entities Can Potentially Reduce Federal Taxes