High-Income Business Owners Escape $10,000 Tax Deduction Cap Using Path Built by States, Trump Administration

Among those that signed up are New York-based law firms including Wall Street powerhouses Paul, Weiss, Rifkind, Wharton & Garrison LLP and Simpson Thacher & Bartlett LLP and private-equity firms such as Cerberus Capital Management LP, according to people familiar with the matter.

Mark Klein,

chairman of Hodgson Russ LLP, said his law firm is using New York’s workaround and that he has worked with dozens of other law and accounting firms that are doing the same. He said the workaround “helps us return to the status quo” despite the $10,000 cap.

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.

“This is becoming the thing the cool kids are doing, if you’re a state,” said

Howard Gleckman,

senior fellow at the Tax Policy Center. “With state assistance, this is a classic case of business self-help in figuring out a way around this.”

The full federal impact isn’t certain, but the momentum is toward expansion as more states and business owners sign on.

Wisconsin, one of the earliest states to implement the workaround, received $326 million from its entity-level tax in 2020, up from $308 million in 2019. 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.

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