One such item was an overall limit on the deduction for state and local property and income taxes. The $10,000 limit is referred to as the “SALT” (state and local tax) limit.
The IRS issued Notice 2020-75 to sanction the use of a pass-through entity (PTE) to avoid the SALT limit.
A state could impose a tax on the PTE rather than the owner. For the income reported by the PTE, the owner could then avoid the SALT limit. This is called the “SALT workaround.”
This past legislative session, New Mexico joined the ranks of states with a SALT workaround. Beginning in 2022, a PTE may elect to be subject to an entity-level tax.
The PTE tax is imposed at the highest statutory rate. Any income taxed to the PTE will be exempt from tax to the owner.
As an illustration, assume that an individual owns all of the stock of an S corporation. In 2022, the S corporation has $200,000 of income that would ordinarily pass through to the shareholder.
With no workaround election, the shareholder reports the $200,000 income on his individual tax return and pays a tax of $11,800. That tax, with any property taxes, is subject to a deduction limit of $10,000.
With the PTE tax election, the entity pays the same $11,800 tax. The individual owner reports no income from the PTE because income taxed to the PTE is excluded from the owner’s income.
This election may avoid the SALT limit. It is made annually. There are several issues to consider in deciding to make the election.
One issue is whether the owners are subject to the SALT limit. This could include whether they itemize deductions, which is required to deduct personal taxes.
Another issue is whether the income could be taxed at a rate lower than the maximum rate. The PTE tax is at the highest rate, the owner’s rate may be lower than that. This is particularly true for net capital gain income.
However, I want to focus on a more basic issue. That is, is the income even reported by a PTE? To have any chance at a SALT workaround, PTE status is required.
New Mexico is a community property state. If spouses establish an unincorporated entity such as an LLC to operate a business, community property rights would mean there are two owners.
An LLC with two owners is usually deemed a partnership for tax purposes. A 2002 IRS procedural rule allows spouses holding their interests as community to disregard the existence of the entity.
We then call this a “disregarded entity,” or DE. New Mexico spouses who hold the only interests in an LLC as community may then avoid a separate PTE tax filing.
It is common for spouses to use the DE option. The LLC income is still reported on their individual return, but as if they earned that income in a sole proprietorship.
The IRS procedure allows the spouses to instead report as a partnership. The partnership decision is made by simply filing a partnership tax return for the year.
New Mexico spouses eligible for this DE or partnership option now have a new wrinkle in their decision-making process. If the SALT workaround is beneficial, they should now treat the LLC as a PTE (partnership).
Continuing to report as a DE precludes use of the new SALT workaround. As noted above, whether the SALT workaround is a good idea depends on the facts of each case.
If there is only one owner of an LLC, it cannot be a partnership. However, this single-member LLC may elect to be taxed as a corporation.
To avoid two levels of tax an S election should also be made. Filing an IRS S election form (Form 2553) will also serve as an election to treat the LLC as a corporation.
Talk to your tax adviser to see if you have a SALT issue. If you can benefit from the new law, another tax return may be required.
James R. Hamill is the director of tax practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at email@example.com.