It’s not just the snowbirds flying south for the winter these days, it is also high income business owners looking to get a break on their taxes. When the federal tax code was revamped in 2017 it imposed a $10,000 cap on the deduction of state and local taxes that hurt those residents of high tax states. Enter Florida. The COVID-19 pandemic has boosted a corporate migration to South Florida from the Northeast, lured by the promise of looser COVID restrictions, lower taxes, and the general draw of all the Sunshine State has to offer. Firms are looking to Florida’s lenient tax structure as a major motivator to move. With the elimination of a state income tax, people are getting more of their money with larger space: it’s a no brainer. However, it’s not just Florida, as states like Texas, Nevada, Alaska and South Dakota, among others, are all vying for your residency.
The individual tax rate allure is one thing, but the business tax structure can be even a more important consideration. The Treasury Department recently approved a way for business owners to avoid the $10,000 cap on state and local tax deductions, ostensibly giving high tax states like New York, New Jersey and Connecticut a little more ammunition in trying to keep high income businesses in their states. While not affecting the corporate income tax, the new law does apply to pass-through businesses, which make up the majority of entities in the U.S. These are typically the partnerships and S corporations, which can include investment funds, real-estate companies, law firms, retailers and manufacturers. While the terms of the actual change in legislation are currently being debated, there is a workaround, so to speak, created at the end of the Trump administration for these business owners. According to then Treasury Secretary Steven Mnuchin, “The Department of the Treasury and IRS are taking the necessary steps to provide fairness for America’s small businesses.”
Ironically, politicians on both sides of the isle have an interest in advancing this legislation. While most of the direct benefit of repealing the $10,000 cap would go to the top 1% of households, Democrats argue that the cap hurts state and local governments. It makes it hard for states to tax their high income residents to provide public services because the full burden falls on the residents instead of being partially offset by the federal provision. Republicans say the deduction provides an unfair federal subsidy to state governments, especially in high tax states, which is why they capped it at $10,000 four years ago. Currently, there are some 20 states that are utilizing this cap workaround. According to Peter Faber, a retired lawyer who specialized in New York State taxes, “If you’re willing to take the trouble of going into the workaround, which shouldn’t be terribly burdensome, then I think effectively, the cap doesn’t exist for you.”
So how does this workaround actually work? As noted, the majority of businesses are so-called pass-through entities that don’t pay taxes themselves. Instead, they pass earnings through to their owners, who report income on individual tax returns. That subjects them to state individual income taxes, and the federal limit on deducting more than $10,000, created in the 2017 tax law. To get around this, the states impose taxes on the pass-through business that are approximately equal to what the owners would pay on their state taxes. The taxes get deducted before any income flows to the business owners. So this is basically a wash to the states, as the reduced individual tax is equated with an increased entity tax. The federal picture is a little different. Since the amount of income going from nondeductible to deductible is increasing, the federal government loses money. How wonderful! According to Howard Gleckman, senior fellow at the Tax Policy Center, “With state assistance, this is a classic case of business self-help in figuring out a way around this.”
Workarounds are not a panacea and can often be difficult. Depending upon the business, it could be doing business in multiple states, some of which may not offer the workaround, thus compounding the effort and the legal and accounting expense to determine the best course of action. One wants to avoid double taxation or harming partners that may be located in states that don’t offer the workaround.
The more the Democrats try to grab, the smarter the business capitalist will become. If a workaround is possible, they will figure it out. Since they are the only shareholder in the pass-through world, they don’t have a Milton Friedman corporate mission to mandate shareholder wealth. Which by the way, is being turned on its head by the new diverse and green boardrooms across America. Is anyone lamenting the failed Steve Forbes flat tax?
