You may recall before the 2017 Tax Cut and Jobs Act, you were able to deduct your state and local taxes on your individual tax return. The 2017 Tax Cut and Jobs Act imposed a deduction limit of $10,000 of state and local taxes on your personal tax return. This has been referred to as the SALT cap. Keep reading below to understand what pass-through entity tax means for your small business.
California work-around to deduct your state taxes at the federal level
For the last couple of years the states have been working diligently to try to find a workaround for this. As of late 2021, California and 18 or 19 other states finally came up with a workaround where they allow for owners of pass-through entities to elect to pay a tax based on a percentage of their taxable income at the entity level which yields a federal tax deduction.
Who does this apply to?
This applies to any shareholders or owners in partnerships, s-corporations, or LLCs that are profitable. We’ve had this apply to most of our clients. This is something that is very beneficial and you should be considering.
How much is this going to save me if I do this?
There’s not a direct answer, however this is an example: if you’re an owner of an S-corporation, partnership or LLC, and the profit of the business is roughly $250,000, you would save about $8,000. We have enough experience with this that we can estimate your net savings is about 3.5% of your federal taxable income from the pass-through entity. In many cases the savings can be much greater than that when there are capital gain events.
Is this a loophole?
No, this is not a loophole. This is simply a change in California tax law. California and 18 or 19 other states created these new laws because the federal government would not allow taxpayers to deduct their state taxes. That’s what was known as the SALT cap, or state and local tax cap.
The IRS has approved this change for all of the states that have implemented it and the have issued guidance for this change.