Opting Out of S Corporation Status at the State Level to Avoid the $10K SALT Deduction Cap
May 28, 2019 — With the Tax Cuts and Jobs Act limiting an individual taxpayer to a $10,000 ($5,000 for married filing a separate return) state and local tax (SALT) itemized deduction, many taxpayers no longer benefit from itemizing their deductions. Limiting state and local taxes to $10,000 often means a taxpayer needs over $14,000 of combined home mortgage interest and/or charitable contributions to get their itemized deductions over $24,000. Instead, they are claiming the standard deduction of $24,000 for married filing a joint return, $18,000 for heads-of-household filers, and $12,000 for all other taxpayers. The state and local tax deduction is a combination of state income/sales taxes, real estate taxes, and personal property taxes.
How to avoid the SALT cap
The S corporation is a flow-through entity that isn’t subject to tax—instead, the individual shareholders pay federal and state tax on their share of income from the S corporation. In order to avoid the SALT tax cap, S corporation shareholders who are filing personal returns in certain states may benefit from their S corporation electing out of S corporation status at the state level.
Generally, an entity taxed as an S corporation at the federal level is also taxed as an S corporation at the state level. However, some states allow the S corporation to elect to be taxed as a C corporation. When entities make this election, the entity pays the state tax on the share of income allocable to the state and the individual shareholders are not required to file tax returns or pay state income tax to that state. Unlike the limitation imposed on individual taxpayers, there is no limit to the amount of state income tax that can be deducted by an S corporation. It is important to note that the tax deduction by the S corporation will reduce qualified business income, resulting in a smaller 199A deduction.
Absent such election, if the state taxes the entity as an S corporation, the individual shareholders will need to file individual income tax returns to report their share of income from the S corporation and the individuals will pay the state tax. All state taxes paid by the individual will be combined and will be subject to the $10,000/$5,000 deduction limit mentioned above. Because of this limitation, the tax benefit of state taxes paid in excess of $10,000 is lost.
Example of potential tax savings
Example 1: One Minnesota resident individual owns a manufacturing operation organized as an S corporation. The corporation has $2 million of taxable income and files in Minnesota and Wisconsin. Income is apportioned 50%/50% to each state based on the sales to each state. The individual has $1,000,000 of income from other sources and is in the highest tax bracket at both the federal and state level. The individual qualifies for the full 20% pass-through deduction.
Option 1: The S corporation files as an S corporation in Wisconsin. The Wisconsin individual income tax rate is 7.65%, so the individual would pay $76,500 of taxes. Since the individual already has over $10,000 of state and local taxes from the income from other sources, none of the $76,500 would be deductible on the federal income tax return.
Option 2: The S corporation opts out of S corporation status and files as a C corporation in Wisconsin. The C corporation income tax rate is 7.9%, so the corporation would pay $79,000 and these taxes would be deductible on the S corporation return. The net tax savings of using option 2 vs. option 1 would be $20,884.
The news is mixed; individuals are still beholden to the SALT cap, but organizations can sometimes avoid the limitation by considering a different choice of entity at the state level. To read more about choice of entity after tax reform, click here to read that article.