Arkansas Adopts SALT Deduction Workaround
One of the much talked about elements of the 2017 tax reform bill known as the Tax Cuts and Jobs Act (TCJA) was the imposition of a $10,000 cap on the state and local tax (SALT) deduction for individuals. Starting in 2018, individual taxpayers who itemize could deduct no more than $10,000 of SALT no matter how much they actually paid.
Almost immediately, states began to look for ways to help their citizens get around the SALT deduction limit, Arkansas being no exception.
During this past legislative session, House Bill 1209 was enacted into state law for this purpose. This new law establishes an elective pass-through entity tax as a workaround to the $10,000 SALT deduction limitation, and is effective for tax years beginning on or after January 1, 2022.
Furthermore, and importantly, unlike some ideas floated by the various states to bypass the SALT limit, this approach has already received the blessing of the IRS, and Arkansas is the ninth state to pass such a law. Here's how it works:
Beginning in 2022, pass-through entities may elect for Arkansas tax purposes to be taxed at the entity level rather than the owner level. Qualifying entities include general and limited partnerships, limited liability companies and S corporations. The election must be made annually and requires a majority of the members with voting rights to approve.
The tax is imposed at a flat 5.9% rate on the net taxable income of the entity, a rate identical to the state's current highest individual tax rate, but lower than the 6.2% corporate tax rate. Entities that have a net long-term capital gain are taxed on only half the gain.
If the tax results in a net operating loss, the entity may carry forward the loss under the state's general net operating loss rules. Additionally, any income tax credit earned under the income tax statutes may be applied to the tax liability of the entity.
Estimated payments will be required. For tax reporting purposes, electing entities must annually report each member's pro rata share of the tax imposed on the entity to the member, and report the member's pro rata interest in the entity to the Arkansas Department of Finance and Administration.
Importantly, the member's income from the ownership interest is excluded from the member's Arkansas gross income when filing an Arkansas tax return. In other words, it doesn't have to be reported on the state individual return at all because the state tax has already been paid.
Members may also exclude the pro rata share of income subject to a similar tax by another state. Further, nonresident owners of an electing pass-through entity are not required to file an individual tax return to the extent it represents their only source of Arkansas income.
So, why would someone want to make this election? There are several reasons to consider it.
First of all, if the tax is paid at the entity level under this election, it becomes a deductible expense of the entity on its federal tax return. There is no SALT deduction limit at the entity level, therefore, the entity's federal taxable income that is passed through to the owners is reduced by the entire SALT deduction, resulting in a lower federal tax bill. Effectively, the SALT deduction is being indirectly taken by the members, subject to no limitation.
Second, many individual taxpayers do not itemize, instead taking advantage of the higher federal standard deductions implemented by TCJA. These taxpayers, who were not getting any tax benefit from the SALT deduction before, will now also have their federal taxes lowered from the “indirect” SALT deduction since.
Also, having lower entity earnings passed through to you means a lower adjusted gross income (AGI), which can sometimes save taxes on other tax items whose treatment is tied to AGI.
Finally, as previously mentioned, nonresidents otherwise required to file an Arkansas return may now be able to avoid the expense and inconvenience of having to do so.
Of course, you should always analyze whether making the election and paying the entity-level tax will result in a lower overall tax burden. In some cases, this may not be true; if, for example, your normal state tax rate is much lower than the 5.9% entity level tax.
However, most tax professionals agree that the majority of taxpayers will likely benefit from making this election. I call this a Win/Win situation, since not only is this new law expected to save Arkansas taxpayers millions, but also is expected to result in increased revenues to the State.
