Private-equity managers and law firm partners are using workarounds to legally circumvent the cap on much of their income. Simpson Thacher & Bartlett’s headquarters in New York.
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Andrew Hinderaker for The Wall Street Journal
Congressional Democrats are debating whether increasing the $10,000 cap on the state and local tax deduction would benefit the rich too much, but some of America’s top earners—including private-equity managers and law firm partners—are already legally circumventing the cap on much of their income.
That is because state governments and the Trump administration blessed a cap workaround for owners of closely held businesses that is proliferating around the country. So far, about 20 states have enacted versions of it, including New York, California, Connecticut, New Jersey and Illinois.
This movement is eroding the bite of the $10,000 cap, and the popularity of workarounds changes the nature of the federal debate about what to do with it. The more that business owners can escape the cap for their state income taxes, the more it falls on high-income wage earners and residents of states that have income taxes but lack workarounds.
“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,” said
Peter Faber,
a retired lawyer who specialized in New York state taxes.
Among those that signed up are New York-based law firms including Wall Street powerhouses Paul, Weiss, Rifkind, Wharton & Garrison LLP and Simpson Thacher & Bartlett LLP and private-equity firms such as Cerberus Capital Management LP, according to people familiar with the matter.
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Mark Klein,
chairman of Hodgson Russ LLP, said his law firm is using New York’s workaround and that he has worked with dozens of other law and accounting firms that are doing the same. He said the workaround “helps us return to the status quo” despite the $10,000 cap.
Here’s how it works. Normally, so-called pass-through businesses such as partnerships and S corporations 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.
Details vary by state, but the workaround flips that concept. The states impose taxes—often optional—on pass-through entities that are roughly equal to their owners’ state income taxes. Those taxes then get deducted before income flows to the business owners.
The laws then use tax credits or other mechanisms to absolve owners of their individual income-tax liabilities from business income. Thus, they satisfy state income-tax obligations without generating individual state income-tax deductions subject to the federal cap.
In these systems, state revenue is virtually unchanged, because the entity-level tax replaces personal income taxes. Business owners win, because every $100,000 of state taxes that go from nondeductible to deductible yields up to $37,000 in net gain on federal income-tax returns. The federal government loses money.
“‘This is becoming the thing the cool kids are doing, if you’re a state.’”
— Howard Gleckman, senior fellow at the Tax Policy Center
“This is becoming the thing the cool kids are doing, if you’re a state,” said
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.”
The full federal impact isn’t certain, but the momentum is toward expansion as more states and business owners sign on.
Wisconsin, one of the earliest states to implement the workaround, received $326 million from its entity-level tax in 2020, up from $308 million in 2019. In New Jersey, pass-through businesses reported $1.3 billion in entity-level liability for the tax’s first year in 2020, suggesting an equivalent amount of federal deductions that might have otherwise been disallowed. In New York, more than 95,000 pass-through entities opted into the tax for 2021 before the Oct. 15 deadline.
“It’s really a slam dunk,” said
Phil London,
an accountant and partner emeritus at Wiss & Co. in New York, who said he has seen the owners of one business save $1.5 million and expects law and accounting firms to use the workaround. “The larger-income entities and real-estate investors and real-estate operators, they’re going to benefit from it.”
Private-equity firms have been particularly interested, said
Jess Morgan,
a senior manager at Ernst & Young LLP. And some businesses have restructured themselves to take maximum advantage of the benefit, she said.
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EY and the other Big Four accounting firms—some of the largest pass-through businesses in the country—wouldn’t say whether they are using New York’s cap workaround for their own partners.
The House-passed plan to change the cap to $80,000 from $10,000 may still matter to business owners. If they have real-estate taxes or state income taxes on personal investments, they can claim federal deductions for those payments up to whatever cap is in place.
Because the workarounds can lower adjusted gross income, they may also offer a way to get a deduction for state taxes against the new surtaxes being proposed for individual income above $10 million and $25 million. That may offer the highest-earning businesses a cushion against other taxes in the Democratic legislation.
After rejecting other workarounds, the Treasury Department blessed these a few days after the 2020 election, citing a footnote in a committee report from the 2017 law and a handful of entity-level taxes that predated 2017. The Trump administration, which had pressed for the $10,000 cap, offered the path out of it.
The notice said forthcoming regulations would offer details. The Biden administration hasn’t issued those rules and didn’t comment for this article. Mark Mazur, who was a senior Treasury official until mid-October, said the regulations were on the to-do list but delayed by other priorities. That lack of full clarity could make some businesses hesitate.
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But “it’s just hard to imagine that they reverse field on something like this,” said
David Kautter,
who was the top tax-policy official at the Treasury Department in the Trump administration and is now at accounting firm RSM US LLP.
The workarounds can be tricky for businesses with owners in multiple states because not all states offer individual-level tax credits for other states’ entity-level taxes. That can lead to double taxation or hurt partners based in states without entity-level taxes.
New York businesses with few out-of-state owners are most likely to sign up, said
Ken Pokalsky,
a vice president of the Business Council of New York State, which pushed the legislation to give pass-through businesses parity with corporations that can deduct state taxes. He expects even more businesses to opt in for future years.
“As the federal recognition becomes more reliable if you will, and as more practitioners become fully familiar with the program, I think it will pick up,” he said.
—Miriam Gottfried, Mark Maurer and Jimmy Vielkind contributed to this article.
Write to Richard Rubin at richard.rubin@wsj.com
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