The 2017 Tax Cuts and Jobs Act (TCJA) was billed as a giant tax cut for everyone, and for many, it has been. For others, the savings were mere pennies each year. However, for many high-income earners in (mostly) blue states, some of the fine print has meant larger-than-expected tax bills. The $10,000 cap on state and local taxes (SALT) can increase the taxable income for most California homeowners before we even consider state income taxes on an average(ish) income.
As a financial planner in Los Angeles, who loves tax planning for my clients, I have some good news to share. Technically, a new tax has been introduced in 29 states, including California, which could allow some taxpayers to avoid getting screwed taxwise from the TCJA, aka the Trump tax plan. Keep reading as we discuss how you can potentially plan for and get a tax deduction for your state and local taxes paid each year.
How The Trump Tax Plan Raised Your Taxes
While “Tax Cuts” is part of the full name of the TCJA- many of my California and New York clients have seen their tax deductions severely limited by the Trump tax plan. The $10,000 SALT cap has severely limited the tax deductions available to homeowners (in relatively expensive areas) and residents of states with moderate to high state income taxes. While nationally, it is estimated that around 11% of taxpayers utilize the SALT deduction, this number is likely far higher in most of California, New Jersey, and New York.
Before the TCJA was enacted, you could deduct all your state and local tax payments against your federal income taxes. Now under the Trump Tax Plan, your deductions are severely limited. For example, if you purchased a house at the median price in Los Angeles of $950,000, your annual property taxes would be around $11,875. I should point out that many basic track houses (in need of work) in many Los Angeles neighborhoods can easily cost $2 million or more.
Assuming you had a job (and income) that allowed you to purchase and afford this home, your SALT taxes would be substantially higher. Assuming you earned around $150,000 (single), your state income taxes would be around the $10,000 SALT cap. While you may have seen your federal tax rates drop with the TCJA, more of your income is likely subject to federal income taxes, partly due to the SALT cap. This fact alone makes proactive tax planning even more valuable.
Can You Alleviate the Sting of the SALT CAP?
You could wait for the SALT cap to expire. Assuming no changes from Congress, the SALT cap limits will expire at the end of the tax year 2025. That still leaves you four more years of getting screwed taxwise by the SALT Cap.
What can you do now to mitigate the tax hit from the SALT cap? Several states (including California) implemented a tax workaround that could be valuable for some taxpayers. There is a new Pass-through Entity tax (PTE tax) that enables your (assuming you have a pass-through entity) partnership, S Corporation (S Corp), to avoid the cap on the SALT deduction. Crazy that a new tax could actually help you lower your overall tax burden.
How Does the PTE Tax Work?
You are probably wondering how the Pass-through Entity tax (PTE) works. To put it as simply as possible, your pass-through entity, as the name implies, passes through all income to partners and shareholders. The income and, therefore, the tax liabilities flow through to individual business owners or partners, who, in turn, pay all of the income taxes on the business income. Regardless of the business’s income, the $10,000 SALT cap applies. To add salt (pun intended) to the wound, two married business owners are also subject to the same total $10,000 SALT cap as one single business owner.
The good news is that a PTE tax allows qualified partnerships and S corporations to pay their state income taxes at the entity level. This is a tax that you have to choose to pay. I can hear you asking through the computer, “Why the EXPLETIVE
As of now, I believe 29 states have adopted some form of PTE tax. I won’t bore you with the details of each state’s PTE rules; consult your tax-planning financial planner, CPA, or other tax professional.
You may also wonder why your tax pro or so-called financial advisor has yet to mention it to you. Assuming you have a pass-through entity, your financial advisor may not know about this valuable tax-planning strategy, especially if that advisor is not a business owner (many advisors are employees of their firms). If you only talk to your tax person when filing your taxes, you will likely miss out on the benefits of a PTE. The payments must be made during the tax year. If you wait until your tax-filing deadline, you will likely miss out on this valuable tax deduction.
Looking At a PTE Tax Example
John and Mike are 50% business partners in a California S-Corp with a net income of $10 million this year. If they get lazy and skip tax planning for their S-Corp, they won’t benefit from a PTE election. In this case, each of them would get a K-1 for $5 million, which would flow through to their personal income taxes. For this example, we will assume they are both homeowners and have used their total SALT cap on their property taxes.
The current top marginal federal income tax rate is 37%, meaning John and Mike would owe approximately $1.9 million (each) in federal income taxes. Each of them would also receive a $665,000 state income tax bill. The top marginal tax rate in California is 13.3%. This puts their marginal tax rate at just over 50% when combining state and federal. You might think, “Each is still taking home around $2.5 million!!!” While that may be true, overpaying your taxes is still painful.
How Much Can the PTE Tax Save You?
Let’s assume that Michael and John have done some proactive tax planning. They elect to have their S-Corp pay the PTE tax. This will seem painful; combined, they will need to pay around $930,000 via their S-Corp to the state of California. ($10,000,000 at 9.3% income). Now, each would have a reported income of $4,535,000 on their K-1 and their federal income taxes due would drop to around $1.7 million each. As for their California taxes, they would each have to report the full $5 million of income, but each would have a $465,000 tax credit against their individual California income taxes. ($930,000/ 2 partners)
Let me break the tax saving down for you, as I know this can get complicated. Each of their California state tax bills would have dropped from $665,000 to just $200,000. The overall tax liability for each partner would drop from around $2.5 million to around $1.9 million. That is roughly a $600,000 tax savings for each of them. That is nearly a 24% drop in income taxes each year.
To be clear, some of these numbers have been rounded for ease of reading. Do not take this article as specific tax advice or a recommendation of any kind. But if you are a high-income earning business owner, you need to work with financial professionals who can help you avoid giving a large tip to the IRS.
Related: How A SBLOC Can Extend Your Tax Savings
Do You Qualify For a PTE Tax?
Like anything taxwise, there are rules that you need to follow to benefit from the PTE tax. To be eligible for the PTE tax break, you must have at least two partners, single entity LLCs are likely not eligible. Tax rates, and eligibility criteria, will differ by state, so talk with your tax pro and financial planner. The PTE tax may be mandatory in some states, but in other states like California, PTE is available but not mandatory.
You will likely need to do some year-end tax planning to get the most benefit from PTE. But as you can see, the tax savings can make the hassle of tax planning more than worth it.