A lot of people were upset last year when the tax reform bill was passed by Congress.
Sure, there were significant reductions in income tax rates for certain taxpayers, corporations, and pass-through businesses as well as a host of other tax incentives. But one big tax benefit was taken away for many: the state and local tax deduction. The bill limited this deduction to $10,000, and that was a big deal for residents in states like California, New York, and New Jersey that have a high local burden.
For regular corporations, there remained no cap on state and local deductions. But for some business owners, particularly the owners of pass-through businesses like S corporations and partnerships, the cap seemed to apply. That's because this deduction is ultimately reported on their personal returns.
But wait ... that rule was just clarified -- and it's good news for many small-business owners.
"There's potentially the opportunity for partnerships or some other pass-through businesses to claim deductions above what they'd be able to do with the capped state and local tax deduction," Jared Walczak, a senior policy analyst at the Tax Foundation, told the Los Angeles Times last week. How?
According to a clarification released by the IRS, pass-through businesses will be allowed to claim a full federal tax deduction for contributions to charities or government programs -- particularly those offering private scholarships -- that offer state tax credits.
"The business expense deduction is available to any business taxpayer, regardless of whether it is doing business as a sole proprietor, partnership, or corporation, as long as the payment qualifies as an ordinary and necessary business expense," the IRS said. "Therefore, businesses generally can still deduct business-related payments in full as a business expense on their federal income tax return."
For example, I have a pass-through client near Philadelphia that donates money to a local private school for scholarships. Under Pennsylvania law, 90 percent of that contribution is eligible for a state tax credit under two state programs. As an individual, she would have to reduce the federal charitable tax deduction she claims by the amount of any credit she received on her state taxes. But as the owner of a pass-through business she won't have to do that and can take the full charitable deduction.
"The IRS clarification makes clear that the long-standing rule allowing businesses to deduct payments to charities as business expenses remains unchanged under the Tax Cuts and Jobs Act," Secretary of the Treasury Steven T. Mnuchin said. "The recent proposed rule concerning the cap on state and local tax deductions has no impact on federal tax benefits for business-related donations to school choice programs."
The state and local tax cap was a hotly contested part of the tax reform bill because Democrats felt that it was politically motivated (many of the high-tax states are blue). The clarification is now stoking even more controversy, because some are accusing the government of changing the rules after it became apparent that taxpayers in many red states would also be affected.
But that's not relevant to you. What's relevant is understanding the rules and working with them to minimize expenses -- particularly large expenses like taxes -- so you can maximize the value of your company. Saving on taxes shouldn't be your primary reason for donating to a good cause. But if you are a fan of school choice or other charitable programs supported by your state, then you should make your accountant aware.