If you’re concerned that you haven’t spent enough on Christmas this year, the Wall Street Journal reassures you that, via your federal income tax payments, you’re subsidizing some of America’s richest private equity partners, $1,500/hour lawyers, etc. “High-Income Business Owners Escape $10,000 Tax Deduction Cap Using Path Built by States, Trump Administration” (12/6):
More than 20 states created workarounds to the limit, and New York’s law firms and private-equity firms are signing up
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.
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.
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.
In other words, many of the richest Americans in high-tax states will be able to deduct nearly all of what would have been their state tax liability, thus keeping the subsidies flowing from workers in low-tax states and from ordinary W-2 slaves who can’t work around what was advertised as the law.