A written testimony before the Council of the District of Columbia, Committee of the Whole on B26-0324, the “Pass-Through Entities Income Tax and Tax Credit on certain S Corporations and Partnerships Amendment Act of 2025” by Nick Johnson at the Institute on Taxation and Economic Policy on March 19, 2026
Chairman Mendelson and members of the Council, thank you for the opportunity to testify today. My name is Nick Johnson. I am a Senior Fellow at the Institute on Taxation and Economic Policy, a tax policy consultant for the DC Fiscal Policy Institute, and a Ward 6 resident.
So long as the federal government is going to allow residents and businesses in other states to benefit from SALT cap workarounds authorized under IRS Notice 2020-75, D.C. residents and businesses should be able to do so as well. My testimony today raises concerns about the bill as introduced and proposes an alternative approach that would better serve the District’s fiscal interests and taxpayers.
Background: The Federal SALT Deduction Cap and Pass-Through Entity Tax Workarounds
The federal Tax Cuts and Jobs Act of 2017 capped the state and local tax (SALT) deduction at $10,000 for individual filers, and last year’s federal tax bill extended the cap although it increased the dollar amount for many tax filers. The expanded cap mostly affects higher-income residents who live in jurisdictions that rely on income taxes to fund public services, including the District of Columbia, because it limits their ability to deduct these taxes on their federal returns.
In response, most states have enacted pass-through entity (PTE) tax elections as a workaround. The IRS blessed this approach in Notice 2020-75. It works like this: A partnership or S corporation that previously paid little or no entity-level income tax is allowed to pay state income tax at the entity level on behalf of its owners. The federal SALT cap applies only to individuals, not businesses. So, since the tax is paid by the entity, it is deductible in full. Owners receive a credit against their individual state income tax liability that is equal to the entity-level PTE tax paid on their behalf, so the state is not raising their taxes. By the way, as explained by OTR in Tax Notice 2022-03, D.C. residents who own PTEs in other states are allowed to claim a credit against the D.C. income tax for PTE tax paid to those states.
The legislation before the Council today represents an effort to bring a similar benefit to District businesses and their owners. Whether or not one views the federal policy of allowing such workarounds as wise, it’s hard to argue that the District should not provide local businesses this federal tax benefit. But it must be done in a way that is fair and appropriate for the District’s somewhat unique tax structure
Problems with B26-0324 as Introduced
B26-0324 is modeled closely on Maryland’s PTE tax statute. Maryland’s law, however, is probably not an ideal model for D.C. to replicate. The Maryland statute was enacted in mid-2020, before the IRS had issued its notice governing these workarounds and is unnecessarily complex, which helps explain why Maryland has amended the statute several times since its enactment.
The following lists specific concerns about the legislation as drafted.
- It creates a new, mandatory tax on “nonresident income” – which is defined here as income subject to the Unincorporated Business (UB) tax – but lacks a meaningful credit mechanism for those taxpayers. This asymmetric treatment — taxing nonresidents without a corresponding offset — raises both policy and Constitutional concerns.
- It lacks an add-back provision. Most states require an individual taxpayer benefiting from a workaround to add-back the value of the credit to their state taxable income; failing to do so creates a D.C. tax reduction that would reduce DC revenue unnecessarily.
- The “distributable cash flow” limitation is unnecessary and adds complexity. Other states don’t have such a limit. Defining the tax base by reference to cash flow rather than income introduces administrative complexity and creates arbitrage opportunities.
- The treatment of tiered ownership structures is overly complicated. The bill attempts to address entities that own interests in other entities through a series of cross-references and carve-outs. Other states address this more simply by limiting PTE elections to entities whose ultimate owners are individuals, not other businesses.
- The credit mechanism may not satisfy IRS requirements under Notice 2020-75. The IRS notice conditions the validity of a PTE workaround on the requirement that the entity-level tax “reduces the partners’ or shareholders’ own individual income tax liabilities under the Domestic Jurisdiction’s tax law.” Because D.C. already exempts unincorporated business (UB) income from the individual income tax, the credit structure in B26-0324 may not satisfy this requirement. This design flaw could invite IRS scrutiny or Congressional action to disallow the workaround.
- The bill raises the effective tax rate on S corporations to 16.5% — the existing 8.25% corporate franchise tax (CFT) combined with the new PTE tax — without a commensurate federal benefit. While the election is optional, the optics would be problematic if many S corporations opt out, limiting the bill’s effectiveness.
- Congressional risk. Congress came close to legislating against PTE tax workarounds in recent years. A poorly designed D.C. statute that attracts IRS or Congressional scrutiny would be worse than no statute at all.
DC Already Has a Partial SALT Workaround, But It Is Flawed
To design a SALT cap workaround for the District, D.C.’s unique business tax structure must be considered. It is not widely recognized that the District already has a de facto SALT cap workaround for businesses subject to the Unincorporated Business Tax (UBT). (Note that not all unincorporated businesses or PTEs are subject to the UBT; there is a major exemption for professional services firms such as law firms and lobbying partnerships.) Under current law:
- Unincorporated business income is taxed at a flat 8.25% rate at the entity level.
- However, D.C. residents get a full exemption of UB income from the personal income tax.
- Because UBT is paid at the entity level, it is not subject to the federal SALT cap, creating a workaround.
In effect, UB taxpayers in the District have been benefiting from a de facto SALT cap workaround all along.
However, this existing system has a significant flaw: the flat 8.25% UBT rate applies to all UB income regardless of the owner’s income level. By contrast, taxpayers who earn non-UB income – wages, salaries, investment income, business income – are taxed under the District’s graduated personal income tax (PIT) rate structure. This creates striking horizontal and vertical inequities:
- Two workers with the same amount of income, say one who owns their own business and another who works for someone else, may pay very different amounts of D.C. tax because one is taxed at the flat UBT rate and the other is taxed at the graduated personal income tax rate. This cuts different ways depending on income levels; for two low-income people, the one paying the UBT rate pays more than the one paying the PIT rate, while for higher-income workers, the one paying the UBT rate pays less.
- Two workers with very different incomes, say a self-employed childcare provider taking home $60,000 in UB income and a consultant earning $600,000 in UB income, both pay the same flat rate of 8.25 percent.
The problem is longstanding, but it has become much more pronounced in the last several years as the District has enacted new higher top PIT brackets while (perhaps inadvertently) failing to alter the UBT rate
A Better Alternative: Reform the UBT Credit to Create an Equitable and Legally Sound SALT Workaround
An alternative approach would address both the equity flaw in the existing UBT structure and the Council’s goal of providing a SALT cap workaround for pass-through entity owners. The proposal has three components:
Step 1: Convert the UBT exemption into a credit.
Under current law, D.C. resident UB owners are exempt from individual income tax on UB income. We propose replacing this exemption with a dollar-for-dollar credit against individual income tax equal to the UBT paid on the owner’s proportionate share of UB income. Under this structure, resident UB owners would include UB income in their individual taxable income and pay tax at their applicable marginal PIT rate (4% to 10.75%) and would receive a full credit for the UBT paid at the entity level.
This reform would:
- Fully retain UB tax revenue.
- Preserve the existing SALT workaround for UB businesses, so they would still be able to fully deduct D.C. tax on their federal returns.
- Restore progressive rate structure for UB income, eliminating the hidden inequity that results from applying the UB rate rather than the PIT rate to business income.
- Reduce personal income taxes for some low- and middle-income UB owners, because they would pay under the graduated PIT rate structure.
- Raise a modest amount of tax revenue for the District, because the revenue gains from high-bracket taxpayers who currently pay a discounted rate likely outweigh the savings to lower-bracket taxpayers.
- Comply clearly with IRS Notice 2020-75 because the entity-level tax now unambiguously reduces the owner’s individual tax liability.
Step 2: Allow non-UB passthrough entities (such as professional services partnerships) to elect to pay UBT.
With the credit mechanism in place, the District can allow non-UB partnerships to opt to pay UBT on a pro-rata basis for their owners. This mechanism effectively extends the existing SALT cap workaround to a broader set of pass-through entity owners, as intended. The result is a policy that closely matches the SALT cap workarounds in other states.
As in other states, this step would avoid a loss of D.C. revenues while providing federal tax savings for participating business owners. Potentially, it could raise revenue for the District, if D.C.-based PTEs elect to pay the tax on behalf of nonresident owners who then claim a credit against their home state’s income tax. An estimate provided to the D.C. Tax Revision Commission by the Office of Revenue Analysis suggested that this change would raise about $14 million a year.
Step 3: Resolve the question of how S corporations should be treated.
Because D.C. already taxes S corporations at the corporate franchise tax rate, adding a second layer of PTE tax may add undue complexity. The simplest approach is probably to exclude S corporations from the new UB tax election.
Conclusion
B26-0324 reflects a genuine and commendable effort to ensure D.C. business owners can take advantage of this federal tax break allowed to residents of most other states. We support the Council’s goal and urge it to pursue that goal through a better mechanism.
The alternative proposed would:
- Provide a clear, legally sound SALT workaround grounded in the District’s existing tax framework
- Allow middle- and low-income UB taxpayers to benefit from the graduated rate structure of the individual income tax
- Generate new progressive revenue for the District
- Avoid the structural and legal vulnerabilities of the Maryland model
I am happy to answer any questions the Committee may have.
Thank you for the opportunity to present this testimony.
