She noted that other types of businesses might leverage the guidance by tinkering with their structure. “We’ve suggested many of our small-business clients who are set up as single-member LLCs or sole proprietorships ... add a [partner] to their business so they can qualify,” Rosen said.
The guidance marks federal endorsement of a state-level workaround for taxpayers that for the past two years the IRS and Treasury Department blocked. With state legislatures scrambling to balance budgets that were wrecked by the pandemic, these workarounds could raise revenue due to higher entity-level tax rates while benefiting constituent taxpayers.
Some question the wisdom of the guidance. “States have not been eager to bog down their own tax codes with convoluted provisions designed to help a small subset of their taxpayers reduce their federal tax liability,” Jared Walczak, vice president of state projects with the Center for State Tax Policy at the Tax Foundation, wrote in a blog. “If states are concerned about their competitiveness for business owners, they would be better served by looking inward rather than further distorting their tax structures and complicating taxpayers’ returns with SALT cap workarounds.”
This guidance may nevertheless inspire “other states, particularly those which have high personal income tax rates, such as California and New York, to quickly enact their own versions of workaround laws,” McGrory said.