The Minnesota Legislature did something nice for a batch of state businesses during the 2021 session: passing a law that could save them hundreds of millions of dollars in federal income taxes.
The change was all the more attractive to lawmakers from both parties because it didn’t cost the state a penny.
Known as the “pass-through entity tax” — and sometimes called the SALT cap workaround — the new Minnesota law followed similar laws passed in at least 22 other states, all aimed at helping businesses get around an unpopular 2017 change in federal law.
That law capped the deductibility of state and local taxes (SALT) at $10,000 per taxpayer. It was seen by some as a way for a Republican Congress and then-President Trump to reduce deductions in high-tax states, which are often Democratic states. The same federal law, however, included other tax-rate reductions that led to more taxpayers choosing standard deductions instead of itemizing deductions like state and local taxes.
“I knew when the Trump tax bill passed that this was going to be a huge problem for blue states,” said Rep. Greg Davids, of Preston, the ranking Republican on the Minnesota House Taxes Committee. “A lot of folks in the past in Minnesota who have been able to deduct their state and local taxes were no longer going to be able to, anything above $10,000.”
But the workaround for business partnerships, limited liability companies and so-called S corporations — think law, accounting and financial services firms — is designed to help. Normally, these entities don’t pay taxes at the business level but instead “pass through” income and tax liability to the owners or partners, who then pay individual income taxes to the state and federal governments.
The new pass-through entity tax plan shifts the tax burden from the individual owners, who are subject to the SALT cap, to the business entity, which is not. Because the state gets roughly the same revenue either way, the state treasury is held harmless.
But the federal treasury is not. And the change means that the affected businesses are now on par with corporations that have been permitted to fully deduct state corporate income taxes from federal taxes.
But it doesn’t help sole proprietors or limited liability companies with a single owner.
“If people are set up to take advantage of the new law, they’re gonna come out quite well,” Davids said.
It was Davids’ House File 1909 that introduced the change and was included by House Taxes Chair Paul Marquart, DFL-Dilworth, in the Taxes omnibus bill passed last summer. Senate Taxes Committee Chair Carla Nelson, R-Rochester, sponsored the Senate version.
A national business association called Main Street Employers has been lobbying states to make the change. The group estimates that if half the eligible businesses elect to pay pass-through taxes instead of individual income taxes, they could save nearly $6 billion, assuming a 30 percent marginal federal tax rate.
The same group estimates that if half of Minnesota’s 163,000 S Corporations and partnerships took advantage of the option, they could save nearly $200 million in federal taxes.
While the federal government has rejected other ways to get around the SALT cap, an IRS ruling in 2020 allowed the pass-through entity tax to proceed.
Nothing in the change helps individual taxpayers who get income from wages who are still under the $10,000 SALT cap, however. Other schemes to that end, and a multi-state lawsuit against the cap, have not been successful. While the U.S. House of Representatives increased the cap to $80,000 in the Build Back Better bill, that legislation recently stalled in the U.S. Senate.
The existence of the new tax plan first surfaced outside of the world of lawmakers, lobbyists and tax accountants last week, when a tax collections report was issued by Minnesota Management and Budget.
At one level, the report on taxes collected by the state in Minnesota showed a continued increase in collection over what was expected. But the Revenue and Economic Update released Jan. 10 also stated that of the $833 million that exceeded predictions, $471 million of it was due to the timing of the pass-through entity tax. That money was paid in December but will be returned to the partners and owners of those businesses through tax credits on their individual income taxes due in April.
Still, the amount paid last month in pass-through entity taxes is far greater than the $50 million MMB had expected in its December forecast.