For small business owners, every dollar counts. This is especially true today. With labor and materials costs rising rapidly, small business owners are looking everywhere they can for savings.
Lawmakers in Frankfort can help with these challenges by passing legislation to allow small business owners to deduct a greater share of their state and local taxes (SALT) from their federal income tax liability. They are often known as “SALT parity” or “SALT cap workaround” legislation. More than two dozen other states have passed such bills to provide federal tax relief for small business owners. These bills utilize a tax structure approved by the IRS and have no impact on state coffers. Small business owners save money through a lower federal income tax liability.
The need for this legislation stems from changes made to the federal tax code by the 2017 Tax Cuts and Jobs Act. One of this bill’s provisions capped the state and local taxes taxpayers may deduct from their federal taxable income at $10,000. The cap does not apply to state and local taxes paid on business income but does apply to taxes paid on individual income. This creates a problem for small businesses, which are structured as pass-through entities and pay taxes on income earned from their business at the individual level. Consequently, the “SALT cap” resulted in higher federal taxes for some small business owners.
An easy solution is to change state law to allow pass-through businesses to pay state income taxes at the entity level instead of at the individual level. Consider, for example, a local car dealership owned and operated by three Kentuckians as a partnership. Under current law, profits from this business pass through to the owners, who then pay state individual income taxes on these profits as personal income. Federal law allows these individuals to deduct their state income taxes from their federal taxable income to help avoid taxing the same income twice. However, the amount of the deduction is capped at $10,000. But if they were allowed to pay state income taxes at the entity level, that cap would no longer apply, and they could fully deduct their state income tax liability. While this arrangement won’t work for every pass-through business, it should be an option when Kentucky business owners could stand to benefit.
Approved by the IRS as an acceptable “workaround” in 2020, 29 states have passed such legislation. This includes Missouri, Ohio, North Carolina, Illinois, and Virginia. Indiana and West Virginia are considering legislation this year, while Tennessee does not levy an individual income tax. Kentucky is one of only ten states with an owner-level individual income tax that does not allow for a pass-through entity tax. That number is expected to shrink soon, making Kentucky an outlier.
Appropriately structured, allowing pass-through business owners to pay state income taxes at the entity level should not impact state revenues. Instead, it will reduce federal income tax liability for these Kentucky businesses by an estimated $40 million per year. That means more dollars that can be reinvested in local Kentucky economies.
With inflation and workforce shortages continuing to hit Kentucky small businesses, now is a great time to provide relief where possible. Changing state law to allow small business owners to deduct state income taxes from their federal taxes fully is an impactful way to provide that relief and support Kentucky’s overall economic competitiveness.
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