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The Basics of State and Local Tax (SALT)
Until recently, one of the biggest federal tax expenditures was the state and local tax (SALT) deduction. According to Treasury estimates, 30% of taxpayers took use of the deduction in 2017, costing the government an estimated $104 billion in lost income.
Taxpayers who itemize their deductions in order to lower their federally taxable income are eligible for the state and local tax (SALT) deduction. When using the SALT deduction, those taxpayers may deduct up to $10,000 in income, sales, or property taxes that they have previously paid to the state and local governments. This ceiling, also referred to as the SALT “cap,” is in effect from 2018 through 2025 and is scheduled to expire after that year.
Because it prevents double taxation, the SALT deduction may be particularly attractive to high-income filers and taxpayers in high-tax states.
Common Tax Types and Business Structures
You take your position on contracts when you form a company, partnership, or LLC. There are further tax advantages if you are operating the firm full-time when you hit a certain income threshold.
Business entities are not free, however. The costs to establish and run a company vary by state. Many individuals decide to engage a lawyer to make sure the company is set up appropriately and continues to comply with local, state, and federal regulations, even if they may be able to complete the registration papers themselves.
Every company and business owner is different, so it might be beneficial to get guidance or tax advisory services from a tax or legal expert on the optimal business structure for your long-term objectives.
1. Sole proprietorship
The most prevalent kind of company form is a sole proprietorship. A sole proprietor “is someone who owns an unincorporated business by himself or herself,” according to the IRS. A sole proprietorship’s main benefit is its ease of use. In this case, there is no separation between the company and its owner, hence the owner is entitled to all earnings. But it also implies that all of the company’s responsibilities, debts, and losses fall within the single proprietor’s purview. This implies that if the company accounts are insufficient to pay the obligation, the business owner’s personal assets and accounts may be accessible to creditors or lawsuit claims. Freelance writers, independent consultants, instructors, and caterers are a few examples of single proprietorships.
2. Partnership
A partnership is defined as “the relationship existing between two or more persons who join to carry on a trade or business” in business structure. There are three major categories for partnerships: limited liability, general, and limited partnership.
General partnership: is made up of two or more partners who equally share all duty and obligation. This indicates that both partners participate in the day-to-day management of the company. Additionally, it implies that each partner has equal responsibility for any obligations incurred by the company. Every partner is regarded as a “general partner.”
Limited partnership (LP): has a minimum of one “limited partner” and one “general partner.” A general partner takes on limitless responsibility as well as control of the company’s activities. A limited partner, also referred to as a silent partner, contributes money to the company. Limited partners, on the other hand, have limited responsibility since they are not engaged in the day-to-day operations and do not have voting rights.
Limited liability partnership (LLP): All partners in this structure have limited personal liability, which shields them from responsibility for other partners’ wrongdoings (such as malpractice or carelessness). An LLP allows all of its members to participate in corporate management. Because partners are free to choose their own management structure, it is often more flexible than earlier partnership types.
3. Limited liability company
It becomes a bit riskier with a limited liability corporation (LLC). An LLC is a “business structure permitted by state statute,” according to the IRS. This indicates that it was established in accordance with state law, and that state laws governing LLCs differ from one another. The IRS may treat an LLC as a corporation, partnership, or as part of the owner’s tax return (i.e., a “disregarded entity” with many traits of a sole proprietorship), depending on the LLC’s elections and features.
Because it has characteristics of many different corporate forms, depending on the owners’ decisions, an LLC is regarded as a hybrid legal entity. Compared to some of its company structure peers, this gives it more safeguards and flexibility. Members of an LLC are not held personally responsible from a protection standpoint. The LLC offers flexibility with respect to federal tax treatment since it is an entity established by state legislation. A single-member LLC, for example, may be taxed as a corporation or as a sole proprietorship. An LLC with several members may be taxed as either a corporation or a partnership.
4. Corporation
A corporation is a business or collection of individuals with the legal authority to operate as a single legal entity. This indicates that there is no personal culpability involved since the business is seen as different from its owners. However, a company may exercise many of the same rights as an individual, which is why it is frequently called a “legal person.” For example, a company has the right to free speech, engage into contracts, and sue or be sued.
The IRS distinguishes between two types of companies: “C corporations” and “S corporations.”
C corporation (C-corp): The default categorization for companies is a C corporation. When submitting their articles of incorporation to the state’s business filing office, all companies begin in the “C” classification. C companies are not a pass-through company, in contrast to our previous business models. Double taxation is the term used to describe their double taxation at the corporate and personal income levels.
S corporation (S-corp): Because a S company is a pass-through organization and may avoid double taxation, it differs significantly from a C corporation. Nonetheless, the IRS imposes stringent requirements, especially with regard to stockholders, on businesses seeking to become S corporations. For example, a S company is limited to 100 stockholders, all of whom must be citizens or residents of the United States. (Startups often issue 100,000 shares of equity in the beginning.)
Multi-State Nexus: What It Is and Why It Matters
By lowering the net cost of non-federal taxes for taxpayers, the SALT deduction gives state and local governments an indirect federal subsidy. For instance, people in the 37 percent federal income tax bracket would pay $63 in net costs if a state raised income taxes by $100 and they claimed the tax increase as a SALT deduction. In other words, the household’s federal taxes decreased by $37 ($100 x 0.37), but their state taxes increased by $100. As a result, this federal tax spending may incentivize state and local governments to raise taxes (and, apparently, provide more services) beyond what they would otherwise do.
Additionally, it could persuade such governments to replace nondeductible taxes, levies, and other charges with deductible taxes (such as selective sales taxes on alcohol, tobacco, and fuel).
The SALT deduction and state and local tax increases, however, are not directly related since tax and spending choices are influenced by the political and demographic makeup of those jurisdictions. For instance, the highest federal income tax rate rose from 35% to 39.5 percent in 2013, which boosted the indirect subsidy of the SALT deduction and thus encouraged state tax rises. However, in the years after this federal tax shift, several states lowered their rates, partly as a result of the political takeover of these states by Republicans who supported tax reduction.
States with Democratic political leadership are usually the ones most impacted by the SALT deduction limit, and they have not significantly reduced their income tax rates in reaction to the $10,000 ceiling.
However, opponents of the SALT deduction contend that state and local taxes should not be funded by the federal government since they only represent payments for the services such jurisdictions offer.
Because a significant amount of state and local government expenditure goes into public welfare, education, health care, and transportation—all of which help individuals in other jurisdictions as well—proponents of the SALT deduction argue that federal subsidies are justified. Some contend, however, that while government assistance could be justified, the significant funds raised by removing or restricting the deduction might be used to directly fund initiatives with the greatest potential for spillover effects via federal grants and loans.
Practical Tips for Compliance and Record-Keeping
Generally speaking, a “SALT audit” is a comprehensive examination carried out by state or municipal tax authorities in a particular state to confirm that companies have correctly recorded and submitted taxes, which may include income tax, use tax, or sales tax. Although payroll taxes and personal property taxes may also be the subject of audits, the sales tax audit is the main topic of this article.
Businesses that operate in numerous states must traverse a complex web of varying standards since each state has its own set of regulations. A formal notification from the state normally initiates an audit, after which the auditor requests records. Depending on the size of your business, the procedure may take weeks or months.