SALT Deduction Sunset Poses Risk of Overvaluation for Businesses

The $10,000 state and local tax cap is one of several parts of the Tax Cuts and Jobs Act that’s expected to sunset at the end of 2025. If it does, it could wallop great estate plans by unraveling underlying business valuations for estate and gift tax purposes, causing costly additional estate and gift tax, interest, penalties, and related professional fees for taxpayers.

Interests in operating businesses that are organized as pass-through entities are frequently the largest portion of an individual’s estate. Getting sound business valuations of PTE interests is paramount to the success of the estate plan.

So what does the SALT deduction limit have to do with the success of business appraisals?

Tax-Affected Earnings

PTEs classified as S corporations, partnerships, and multimember LLCs pay no federal income tax at the entity level. PTE income is simply reported to its owners, who pay any income tax due.

Business appraisals for federal tax purposes must use fair market value, which per Rev. Rul. 59-60 is “the price at which the property would change hands between a willing buyer and willing seller when the former is not under any compulsion to buy and the latter in not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”

Such appraisals are benchmarked against an after-tax cost of equity (the expected rate of return on investment). For consistency, earnings must be “tax affected” to reflect the economic reality of taxes due on such earnings.

Tax affecting is the process of converting PTE earnings from pre-tax earnings to after-tax earnings. First, a blended tax rate is developed to include the federal, state, and local income tax rates. Next, the blended tax rate is applied to PTE earnings to derive estimated income taxes payable, which are then deducted from pre-tax earnings to produce after-tax earnings.

This process remains a highly contentious issue in IRS business value disputes, even though it’s a settled issue among business appraisal professionals. Over the last two decades, the US Tax Court has shown no inclination to correct poorly developed calculations of tax-affected earnings.

In such cases, the Tax Court tends to throw out tax affecting altogether, effectively blessing business valuations by the IRS based on pre-tax earnings rather than on after-tax earnings. This often results in overvaluation of business interests and far greater liabilities for estate and gift taxes, interest, and penalties.

Monkey Wrench

The $10,000 SALT cap’s passage prompted 36 states and one city to enact workarounds via pass-through entity tax options, allowing PTEs to pay and deduct state and local income taxes at the entity level. This enables them to circumvent the federal SALT deduction cap.

Just last month, the US District Court for the Southern District of New York threw out a challenge to the SALT deduction cap filed by the states of Connecticut, New Jersey, and New York.

At issue were these states’ attempts to allow residents to donate to charity and earn equivalent credits against state and local income tax liabilities, which are largely negated by federal limits on such deductions by the amounts of these credits. The court found that Connecticut and New Jersey lacked standing, as they never enacted such tax credit programs, and that New York didn’t show injury. Workarounds are likely unaffected by this ruling.

A PTE can opt to file an income tax return that includes a new workaround-related SALT deduction, whereas no such deduction was allowed or taken before the TCJA. Consequently, if the SALT workaround option is elected, the effective tax rate used for tax affecting now must exclude the impact of personal state and local income tax rates to avoid double dipping.

Only one benefit of a state income tax deduction is allowed, and that can be accomplished through either an actual deduction for SALT or through tax affecting—but not both.

The SALT cap enables an appraiser to more easily overlook the SALT deduction taken and fail to adjust the effective tax rate while tax affecting earnings. Given the IRS’s disdain for tax affecting—and the Tax Court’s apparent unwillingness to recalculate effective tax rates—accuracy in tax affecting of earnings is paramount.

Improper application of tax rates increases the likelihood of tax affecting disallowance, along with assessment of additional estate and gift taxes, interest, and penalties—not to mention legal and other professional fees required to defend the taxpayer.

Let’s say there’s a PTE appraisal with a $1 million SALT deduction on the income statement, but the appraiser still includes the SALT tax rate when tax affecting, doubling the benefit. Assuming a 15% capitalization rate, this $1 million overstatement of expenses leads to a $6.7 million valuation understatement.

At a 40% estate and gift tax rate, that’s a $2.7 million underpayment of tax excluding additional penalties, interest, and professional fees.

Suppose the $10,000 SALT limit expires when the TCJA sunsets and taxpayers are again able to deduct their state and local income taxes. The renewed deductibility of SALT on personal income tax returns would remove a large incentive for PTE owners to pay pass-through entity taxes.

Then, the peril would revert to a situation where a PTE was taking no SALT deduction at the entity level—but out of habit, the appraiser omits consideration of state income tax expense when tax affecting the entity’s earnings. Earnings and fair market value of the PTE interest would be overstated, which could lead to needless overpayment of estate and gift tax by the taxpayer.

Takeaways

Exactly one income tax benefit is allowed from the payment of state and local income taxes—whether by deduction at the entity level or by inclusion of the state and local income tax rates in the blended tax rate used in tax affecting earnings.

It’s crucial to invest in a high-quality business appraisal by an appraiser who is competent in IRS estate and gift tax matters. Someone who’s experienced in IRS disputes provides a helpful safety net for taxpayers.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Bruce C. Wood is partner at BW Arpeggio in Alpharetta, Ga.

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