IRS analysis good enough for government work

There is an old joke that involves three people who must answer a seemingly simple question: what is two plus two?

The protagonist of the story is either a lawyer or a CPA.

At the end, the lawyer/ CPA leans over and quietly asks, “What do you want it to be?”

A well-known tax attorney once said he thought every client needed two tax advisers. One would tell the client what the law was, the other what he wanted the law to be. Then he would choose.

In February, New Mexico joined the club of states adopting a “SALT workaround.” SALT stands for “state and local taxes.” Federal law now limits the deduction for income and property taxes paid by an individual to $10,000.

The $10,000 is called the “SALT cap.” Some people are leaving large tax deductions on the table because of the cap. This is not the answer that they want.

States started thinking about how to get their residents the answer they wanted. The workaround was conceived for those who operate some activity in a “passthrough entity,” (PTE) such as a partnership or S corporation.

The idea is to impose a state tax on the PTE income. The PTE would pay the tax imposed on it. The owner of the entity would claim a credit for the tax paid by the entity.

A 64-year-old IRS ruling said that if an Ohio PTE paid a tax imposed on the entity by the City of Cincinnati, the tax would be reflected in the income or loss reported by the PTE.

IRS issued a notice in 2020 that cited this ruling as well as legislative history to the 2017 change in the law that created the SALT cap. The legislative history said the cap would not apply to a tax imposed on a PTE.

Thus, the PTE workaround was born. It has multiplied across the land like rabbits. If you are one who has, or can create, income in a PTE, you may elect to treat state tax as imposed on the entity.

If you have nothing but W-2 wages, you won’t be able to have those wages deemed earned by a PTE. No workaround for you. Business income is best, investment income should also be acceptable.

If the IRS says something is OK, is it OK? Well, you say, there is no one to challenge me if the IRS will not do it. Perhaps so, but when IRS says something is so, and there is no other authority supporting that statement, IRS can later say it ain’t so.

Most tax advisers are positively giddy about the SALT workaround. They may boast of their knowledge of it and seek out clients to profit from its use.

Who would deny a tax adviser that rare opportunity to be giddy? Well it turns out there is one well-known tax adviser who has raised an eyebrow at fellow professionals going gaga.

In the interest of fairness, a trait that I occasionally subscribe to, this adviser’s questioning relates more to the thoroughness of the IRS analysis than to outright condemnation of its conclusion.

The tax expert is Monte Jackel, who formerly held several key positions with the IRS Office of Chief Counsel. Jackel raises the issue – are these taxes actually imposed on the PTE or are they withholding taxes paid by the PTE on behalf of the owners?

Jackel says of the IRS notice, “(it) is undoubtedly incorrect without its first containing an analysis as to why these types of taxes are, or are not, withholding taxes.”

Jackel cites an old Supreme Court case that held that a partnership’s payment of a partner’s share of a tax liability is a deemed distribution to the partner.

Again, let me make clear that Jackel does not say the workaround cannot work. He instead criticizes the IRS analysis for being incomplete.

At a minimum, a proper legal analysis would have to consider the wording of the specific state law. What happens if the PTE fails to pay the tax supposedly imposed on the entity?

The IRS analysis is, as Jackel says, deficient. Yet IRS is now the adviser that explains the law the way you want it to be.