For Maryland Taxpayers, a Tough Ruling

“All income is taxable unless the tax code says it’s not; all expenses are not deductible from that income unless the tax code says they can be deducted.”

Maryland Smith accounting lecturer Sam Handwerger recites this basic tenet multiple times every semester. It’s a fundamental lesson that every accounting student must learn. “It’s ‘Intro to Income Taxation’ stuff,” Handwerger says.

And it will come in handy throughout their careers. “This gets to the heart of our income tax law. We are taxed on net income, after expenditures – not on the gross – with the proviso that Congress gets to decide what you can deduct to get to that net,” Handwerger says, in words he’s likely repeated dozens of times.

In October, the Second Circuit Court of Appeals confirmed the constitutionality of that basic tax principle, ruling that the $10,000 income tax deduction limit of State and Local Tax (SALT) as passed in the 2017 TCJA law is valid.

The law had been challenged by four higher-income-taxing states, Handwerger says, “for the obvious concern that their residents were being unduly hurt by this limitation.”

Fearing their residents would demand lower taxes or leave their state for lower-taxing venues, these states argued that the law unjustly hurt their sovereign ability to collect and raise tax revenue. “That might be a fair assessment of what the law in effect does,” says Handwerger, “but it’s not enough of a reason for Congress to be unable to legislate the $10,000 deduction limit, so said the Court of Appeals.”

What’s next

Anticipating that the constitutional argument would fail to gain relief, the higher-income-taxing states have been busy on two fronts, says Handwerger, a CPA and a full-time accounting lecturer at Maryland Smith. First they are appealing to Congress to overturn the deduction cap. The prospects initially seemed encouraging. The Democrats seemed poised to quickly revoke the limit after the 2020 election, but the price tag of lower federal tax revenue has “so far deterred the overturn,” says Handwerger.

The second strategy, he notes, has been yielding better and more fruitful results. “This is what some call the ‘SALT workaround,’” says Handwerger.

Endorsed by an IRS ruling in 2020, the workaround is basically accomplished where the state legislates a state income tax on certain pass-through businesses in lieu of an income tax on the owner of that business. This works for S corporations and Limited Liability Companies (LLCs), where the income from the business is generally passed through to the owner, who in turn pays the income tax.

By rearranging the tax on the income of the business to be at the business entity level – rather than at the owner level – there is no limit on the amount of deduction allowed for the state income tax by the business. The limit applies only to individual taxpayers. “This clever little workaround has now been legislated by almost 20 states, with more coming around the corner,” says Handwerger.

“The result? High income-tax-states have eased the pressure on business owners in their state to leave for sunnier climates like Florida, where there is no income tax.”

And that sounds good. But, well, there’s always a “but,” says Handwerger.

“The benefit works only for business owners, and in particular for business owners in these pass-through entities. Doesn’t work for the employee of a business or owners of C corporations. Thus, in an effort to “work-around” a tax law, some tax fairness disparities open up.”

Employees can’t simply create their own business and have the business become the “employee” in order to take advantage of this loophole, in effect paying their state income tax as an S corporation or LLC, he says. The complex employee-versus-independent-contractor rules step in here to prohibit playing that game.

In short, he adds, “If you are an ‘employee,’ you’re stuck paying tax as an individual and being subjected to the current $10,000 limitation .”

Now, Congress is now back at the drawing board, Handwerger says.

“With the workaround laws gaining steam, the once projected tax revenue from the SALT limit is now being eroded, undermining the government revenue gain anticipated by that limit. Admittedly not entirely, but at an alarming rate,” he says. “Presumptively, Congress will soon have to do something.”