The Final Tax Reform Act: SALT Implications

by McDermott Will & Emery

McDermott Will & Emery

In Depth

We finally have a federal tax reform act. President Trump signed the Act on December 22, 2017. Many commenters ventured guesses on what the Act would contain, if passed, and what its SALT implications would be, but up to now it has all been speculation (see, e.g., Peter L. Faber, “House and Senate Tax Reform Bills: SALT Implications,” State Tax Notes, December 11, 2017). The reactions of the states to the federal law will still be a matter of conjecture, but at least we know the federal law to which they will be reacting.

State legislatures will have to consider the extent to which state statutes, which typically base state taxable income on federal taxable income, should be modified to reflect the Act’s language and policy decisions. State revenue departments will participate in this process, and it is important that the private sector do the same. This article will point out some of the state and local tax implications of the Act, but it is by no means intended to be a comprehensive survey.

The reductions in individual federal tax rates will not have an immediate impact on SALT liabilities, but the expansion of the standard deduction and the suspension of the deduction for personal exemptions will affect the federal taxable income of many individuals, and these changes will pass through to their state income tax returns in states that use federal taxable income as the base for calculating state taxable income. 

The reduction in the corporate income tax rate from 35 percent to 21 percent has had a different consequence. Many accrual basis corporations that were in the process of resolving state and local tax audits that involved deficiencies wanted to pay the deficiencies in 2017 even though the cases had not formally been resolved so as to deduct the payments against income that was taxed at a 35 percent rate rather than at a 21 percent rate, which will apply in 2018. Section 461(f) of the Internal Revenue Code provides generally that an accrual basis taxpayer can deduct the payment of a contested liability, including tax liabilities, as long as the payment is an actual payment and not merely a deposit. Transmittal letters with payments were drafted with care to make clear that the payment became the property of the government and that partial refunds in the event of overpayment could be obtained only by claiming a refund using the normal procedures.

The Act allows state and local income and property taxes to be deducted up to $10,000. This will effectively amount to a repeal of the deduction for state and local income taxes for high-income individuals and can be expected to have a particularly adverse effect on high-tax states such as New York and California. When the Act was making its way through Congress, there was some speculation that it might be possible for individuals to prepay all or part of their 2018 estimated personal income taxes in 2017 so as to get a federal deduction for them. It was not clear how the Internal Revenue Service (IRS) would have reacted to such a strategy, although the laws of many states permit such a prepayment. In any event, the strategy was foreclosed by a last-minute change that provided that payments of 2018 personal income taxes in 2017 would not be deductible in 2017. That change did not apply to real property taxes, and several states amended their real property tax laws before year-end to permit pre-payment. The IRS has announced that pre-payments of 2018 taxes in 2017 will be deductible in 2017 only if the tax is assessed in 2017, “which is generally when the taxpayer becomes liable for the property tax imposed” (IR-2017-210 (Dec. 27, 2017)). The IRS position means that voluntary prepayments that are not assessed will not be deductible when paid. It is not clear that a court would support this position.

State and local property taxes that are incurred in a business are clearly exempt from the deduction disallowance. There is no similar carve-out for state and local income taxes paid by individuals on business income. It seems likely that the carve-out was intended to apply to taxes paid by a business entity on business operations (e.g., sales and use taxes, property taxes) and not by individuals who receive compensation income or profits from the business, but this is still to be determined. An interesting variation on this theme involves entity-level taxes on partnerships such as New York City’s unincorporated business income tax (UBT). A partnership conducting business in New York City files a UBT return and pays a tax on its net income as computed for purposes of the tax. The tax is not paid by the partners individually. One can make a case that this tax should be deductible by the partnership on its federal partnership income tax returns and that the deduction should be passed through to the partners in computing their net income from the partnership. A similar case can be made for the UBT paid by a sole proprietor because, although the tax is effectively paid by an individual, the sole proprietorship is treated as an entity for UBT purposes. If a UBT paid by a partnership is deductible for federal income tax purposes but a UBT paid by a sole proprietor is not, will we see sole proprietorships converted to partnerships by the admission of a family member as a 1 percent partner?

The Act allows taxpayers to deduct the cost of qualified business property in the year placed in service if the property was placed in service after September 27, 2017 (the date that the White House and Congressional leaders released their tax reform “Framework” outline kicking off the tax reform effort in earnest, and proposing expensing with this effective date). The 100 percent deduction is phased down to 20 percent beginning in 2023. The original use of the property need not begin with the taxpayer, although the taxpayer’s first use of the property must begin after September 27, 2017. Anti-abuse rules are provided to prevent the effective date provision from being avoided by selling property to a related taxpayer.  

In the past, many states have not conformed to federal accelerated depreciation rules, reasoning that accelerated depreciation (that is, depreciation that is faster than economic depreciation) represented a federal subsidy that the states might not want to adopt. One hundred percent expensing of the cost of property is the ultimate form of accelerated depreciation, and it is likely that some states will choose not to adopt it. This would require a legislative change in states that define state taxable income in terms of federal taxable income. 

Related to the expensing provision are limitations on deducting business interest. If companies could buy expensed property with borrowed funds and deduct the interest paid to the lender, they would arguably be realizing some form of double benefit. The Act limits the deduction for net business interest expenses to the sum of business interest income and 30 percent of the business’s adjusted taxable income. Disallowed interest can be carried forward to the next taxable year. Businesses with gross receipts of $25 million or less are exempted from the disallowance. 

State legislatures should keep in mind the linkage between expensing and the interest deduction disallowance. If a legislature chooses not to adopt expensing, it should also not adopt the interest disallowance. It will be important for taxpayers to point this out to legislators and legislative staffs as well as to state revenue departments during their consideration of changes to be made in light of the Act.  

The Act would include in a corporation’s income contributions to its capital by a governmental entity or civic group (other than a contribution made by a shareholder as such) and a contribution in aid of construction or a contribution in the capacity of a customer or potential consumer. State and local governments have often used capital contributions to subsidize desired economic activity. A state that adopted the new federal rule would in effect be undermining its own economic development policies, and states should seriously consider not adopting the federal change. 

The Act limits the use of net operating loss (NOL) deductions. NOL carryovers now can be deducted only to the extent of 80 percent of the taxpayer’s taxable income otherwise computed, and NOLs cannot be carried back. On the other hand, they can be carried forward indefinitely, not just for 20 years. These rules apply to losses arising in tax years beginning after 2017. Many states have special NOL rules that depart from the federal rules. State legislatures should consider whether and to what extent to conform to the new federal rules. 

The Act has complicated provisions designed to provide for a lower rate of tax on business income realized by pass-through entities that is taxed to their owners. This is implemented by allowing a deduction of 20 percent of qualified income, determined at the entity level. Complicated protective provisions are intended to prevent the resulting low rate from being used by investment companies or professional service firms (with the exception of a carve-out for engineering firms and architectural firms). Qualifying income is limited by percentages of W-2 wages paid to employees.

The states will have to decide whether to adopt some variation of the pass-through rules. The benefit is provided through a tax deduction at the entity level, so states that conform to federal taxable income will automatically conform to the pass-through deduction unless they decide to decouple. The provision is presumably intended to provide an incentive to pass-through entities and to give their owners something comparable to the reduced corporate tax rate.

The Act provides that gain or loss realized by a foreign partner from the sale of an interest in a partnership that is engaged in a US business will be treated as effectively connected with the US business and, hence, will be taxable if the seller would have had effectively connected gain or loss if the partnership had sold all of its assets at their fair market values on the date of the sale. This was intended to overrule the US Tax Court’s decision in Grecian Magnesite Mining v. Commissioner (149 TC ___, No. 3 (2017)) and to codify Revenue Ruling 91-32. This provision presents an interesting SALT issue: if the selling partner and the partnership were not engaged in a unitary business, can the gain constitutionally be taxed by a state if the partner has no other nexus with the state? States are likely to assert that it can, but the issue is not free from doubt, and we are currently litigating a case involving that issue. 

The Act addresses the treatment of carried interest income but in a manner that is unlikely to have serious consequences for the hedge fund and real estate industries. A carried interest is an interest in a partnership or limited liability company that is received by the venture’s organizers and that typically involves a 20 percent interest in the entity’s profits even though the promoter has contributed 1 percent or less of the entity’s capital. This structure is often used in hedge funds and other investment partnerships. If the fund realizes long-term capital gains, these are passed through to all of the partners, including the promoters.

Some people have argued that the promoter’s share should be treated as ordinary income because it represents partial compensation for the promoter’s services. The Act provides that the promoter’s share of capital gains will be short-term capital gains taxed at ordinary income rates unless the partnership’s property that was sold had been held for at least three years. This change will not affect states that do not provide special treatment for capital gains.

The Act does not treat carried interest income as compensation income, which is another approach that some people have suggested. If that approach had been followed, the change would have had dramatic state and local tax consequences because compensation income is typically taxed to nonresidents who earn it in a taxing state, whereas capital gains on securities are typically not taxed to nonresidents. States that do provide special treatment for long-term capital gains will have to decide whether to conform to the new federal rules.

The structure of international taxation has been significantly revised. The Act reflects a shift to a territorial system of taxation under which dividends from foreign subsidiaries will not be taxed to US corporations. As part of the shift to the new system, a so-called “transition tax” will be imposed on previously accumulated earnings and profits of foreign subsidiaries, whether or not they are brought back to the United States. Although the publicity about this provision has described it as providing for low rates of tax—15.5 percent if attributable to cash or cash equivalents and 8 percent if attributable to illiquid assets—the provision operates in a manner that will have state and local tax implications. New section 965(a) provides that all of the accumulated earnings and profits of the foreign subsidiaries will be included in the US parent’s subpart F income and, hence, taxed to the parent under Internal Revenue Code section 951(a). New section 965(c) then provides for separate deductions that, when coupled with the inclusion, will produce the 15.5 percent and 8 percent effective rates. The taxpayer may elect to pay the resulting tax liability over eight years. 

If a state simply conforms to the federal definition of taxable income, the combination of the income inclusion and deduction will result in a tax at a lower rate than the state’s nominal rate. However, many states provide for a whole or partial deduction for dividends received from subsidiaries. It is generally believed that subpart F income is treated as a dividend for this purpose since it is based on the foreign subsidiary’s earnings and profits and is treated conceptually as if it were an actual dividend. As such, subpart F income is not taxed by many states. Although there is some authority to the contrary, this seems like the right conceptual result. New York’s statute is more explicit: it specifically exempts income that is included in federal income under section 951(a).

If the section 951(a) income is excluded from state gross income, is the 965(c) deduction nevertheless available? This may be the result under many state statutes, in which case taxpayers will get a windfall. States may attempt to correct this by legislation, but any such legislation would be retroactive because the inclusion and the deduction are effective in 2017. Whether retroactive legislation would be constitutional is a separate issue. Most state courts that have addressed retroactivity issues in recent years have upheld retroactive legislation, and the Supreme Court of the United States has declined to hear appeals. There may be constitutional issues if states include the section 951(a) income without taking into account the apportionment factors of the controlled foreign corporations (CFCs) that produce that income. 

Similar issues arise with respect to the new tax on global intangible low-taxed income, generally referred to as GILTI. A US shareholder of a CFC will have to include in gross income its share of certain CFC intangible income under new Code section 951A and will get a partially offsetting deduction in new section 250 that will have the effect of reducing the effective tax on the income. If the section 951A inclusion is treated as a dividend, the same issues will arise as are present with respect to the transition tax of section 965. The argument that 951A income is a dividend may be weaker because the income inclusion is not determined by reference to the CFC’s earnings and profits. State legislatures will have several choices here, including whether to include the 951A income in state income and whether to allow the deduction.

The Act suspends all miscellaneous itemized deductions that are now subject to the 2 percent floor provided by Internal Revenue Code section 67. States will have to decide whether to decouple from these changes. The deductions include deductions by employees of trade or business expenses incurred in their employment. This means that employees will not be able to deduct expenses such as local business travel, subscriptions to professional publications and professional organization dues, even though their self-employed counterparts will still be able to deduct them. State legislatures may choose to decouple from this provision because of its impact on individuals. The Ways and Means Committee’s explanation of the House Bill indicates that the expansion of the standard deduction and the lower overall tax rates will reduce the adverse impact of this change and that the change will spare employees the need to keep track of business expenses, but this will be of no comfort to higher-income employees. 

The Conference Committee deleted the provision in the House Bill that would have repealed the estate tax and generation-skipping transfer tax, beginning in 2023. Instead, it adopted the Senate approach of simply increasing the exclusion from about $5.5 million to about $11 million. Had the estate tax been repealed, it would have been necessary for states desiring to have an estate tax to draft their own detailed statutes because there would no longer be Internal Revenue provisions to incorporate by reference. The increased exclusions could result in reductions in state revenues, and it is possible that some state legislatures will choose not to incorporate them. 

The Act contains a number of provisions that will affect tax-exempt organizations. 

Exempt organizations will be required to pay an annual excise tax on compensation exceeding $1 million paid to their five highest-paid current or former employees. The tax will apply to both current compensation and deferred compensation. The tax will be 21 percent of compensation exceeding $1 million, which corresponds to the tax rate imposed on business corporations. A limited carve-out applies to payments made to licensed medical professionals for the performance of medical services. Effectively, this means that, in the case of medical institutions, it will apply only to administrative and executive officers. As a separate excise tax, this tax will not automatically become part of state tax structures unless state legislatures choose to impose their own version of the tax. This may be tempting politically because it could be viewed as a tax on wealthy people (even though paid by the institution), and affected organizations may want to communicate their views on this to state legislatures. 

Another new tax would be imposed on the investment income of private colleges and universities with substantial endowments. The Act imposes a 1.4 percent excise tax on the net investment income of private educational institutions with more than 500 students and with aggregate assets exceeding $500,000 per student (excluding assets used directly in carrying out the institution’s exempt purposes, such as buildings, computers and other equipment. Here, too, state legislatures may be tempted to impose their own versions of this tax. 

State revenue departments and legislative staffs have begun to consider these issues, and we can expect that changes will be made in 2018 to address many of them and other issues not covered here. It is important that taxpayers get involved in the legislative process in the states. Many of us have already been contacted by state officials seeking guidance on possible changes. It is likely that the states will approach tax reform in a deliberate and thoughtful manner, and interested parties should make sure that their voices are heard.


DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© McDermott Will & Emery | Attorney Advertising

Written by:

McDermott Will & Emery

McDermott Will & Emery on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Custom Email Digest
Privacy Policy (Updated: October 8, 2015):

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.


JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at:

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.