Governor and Lawmakers Propose SALT Deduction Cap Workarounds

The governor and the legislature introduced separate proposals to provide California taxpayers with a workaround of the federal SALT deduction limit.

California lawmakers and Governor Gavin Newsom separately proposed a workaround of the $10,000 cap on Federal tax deductions for state and local taxes (SALT) that was implemented under the Tax Cuts and Jobs Act (TCJA). Removing the SALT deduction limit is a major priority for Democrats at the Federal level.

In November 2020, the IRS approved tax mechanisms in several states to avoid the SALT deduction cap by using an entity-level tax on owners of pass-through businesses. The IRS stated that these entity-level tax payments will not be taken into account in applying the SALT deduction limit to an individual partner or an S corporation shareholder that pays the tax. This allows the pass-through entity to pay the tax in exchange for a reduction in the state income tax liabilities of the individual members.

Legislative proposal

SB 104 would give pass-throughs (partnerships, limited liability companies, and S corporations) the option to pay an entity-level income tax that would be fully deductible by the individual members of the pass-through businesses. This applies to tax years 2021 through 2025, when the $10,000 SALT deduction cap expires.

Governor’s proposal

In the proposed budget, released on January 8, 2021, Governor Newsom proposed to apply a SALT workaround for S corporations, which are taxable at the shareholder level in California. In the proposal, S corporations would have the option to pay a 13.3% income tax rather than the current 1.5% on S corporations, and shareholders would then have a tax credit equal to 13.3% of their passed-through income. The limit to S corporations narrows the law to individuals, as corporations cannot hold shares in an S corporation.