In the runup to this year’s federal tax debate, Congressional tax writers faced two important issues relating to the so-called “SALT cap” on itemized deductions for state and local taxes: the level of the cap and whether the very richest Americans should be subject to that cap. The new tax law enacted last month found a temporary compromise on the level of the cap, boosting it to $40,000 through 2029, but failed to fix a loophole that allows some rich taxpayers with good accountants to completely avoid the cap. This result confirms the widely held view that our nation has two tax systems: one for the best-off Americans and another for the rest of us.
The ”SALT cap,” enacted in 2017 as part of the Trump administration’s first major tax cut, was the result of a longstanding debate over the fairness of allowing individuals to claim an unlimited itemized deduction for state and local income, and property (SALT) taxes.
While the deduction reserved its largest tax benefits for the best-off Americans and had a huge price tag, it also provided what amounted to a matching grant to states that chose to fully fund public investments using progressive income taxes, an implicit form of federal aid to states. This matching grant discouraged states from pursuing a “race to the bottom” in top personal income tax rates. The 2017 tax law temporarily capped the individual SALT deduction at $10,000 for eight years.
But while the new SALT cap was felt acutely by many upper-middle-income families living in high-tax coastal states like California, New Jersey and New York, that pain was not shared by some of the very best-off taxpayers in these states.
This is because state lawmakers almost immediately began seeking legal ways of circumventing the cap, and ultimately 36 states enacted workarounds that allowed some well-heeled taxpayers to entirely avoid the cap by recharacterizing their personal income as business income using pass-through entities (which are not subject to any cap on the amount of SALT taxes they can deduct federally). These state workarounds undermined tax fairness and reduced the yield of one of the 2017 tax law’s few meaningful revenue raisers.
In the few states that have published basic data on who benefits from the workarounds, it’s clear that these tax dodges overwhelmingly benefit the very best-off. For example, data from Maryland show that of the $657 million in pass-through entity credits claimed by Marylanders in 2023, 84 percent went to taxpayers with incomes over half a million dollars.
The sensible hope was that the 2025 expiration of the SALT cap would give lawmakers a second chance to craft a more equitable solution on the SALT deduction issue. A glimmer of hope came when the House-passed version of the 2025 tax bill included a provision that would have limited the use of workarounds by pass through entities in legal, accounting, and medical firms by stating that these workaround taxes would count toward the SALT cap, although the House bill would also have left the workarounds in place for many other businesses.
But the Senate dropped even this limited language, and the legislation ultimately enacted last month was entirely silent on the workaround issue. The new SALT deduction limit, which is $40,000 for most taxpayers and gradually phases down to $10,000 for those with incomes over $600,000, thus leaves intact the ability of some people with good legal and accounting help to completely skirt these caps.
But the SALT workaround saga doesn’t have to end here. The haste with which the new tax law was written means that Congress will likely soon work on a “technical corrections” bill cleaning up errors and unintended consequences of the recently enacted law. Tax writers could, and should, take that opportunity to explicitly prohibit the use of state pass-through entity workarounds to avoid the new $40,000 SALT cap, with legislative language that says all pass through entity workaround taxes count toward the cap. Failing to do so would confirm the worst fears of the many taxpayers who believe the wealthiest Americans are allowed to play by a different set of rules than the rest of us.
