Secretary Mnuchin’s SALT “Clarification”: A Lesson in Political Geography?

Daniel Hemel
Sep 9, 2018 · 5 min read

Tax scholars and practitioners have been scratching their heads over the past few days regarding IRS Notice 2018–78, which purports to clarify the proposed regulations that the IRS issued last month regarding state charitable tax credits. In a press release accompanying the notice this past Wednesday, Treasury Secretary Steven Mnuchin said that “the longstanding rule allowing businesses to deduct payments to charities as business expenses remains unchanged.” Yet as Andy Grewal and others have noted, there is no longstanding rule allowing businesses to deduct payments to charities as business expenses. Rather, longstanding Treasury regulations allow businesses to deduct transfers to charities as business expenses only when those transfers “bear a direct relationship to the taxpayer’s trade or business” and “are made with a reasonable expectation of financial return commensurate with the amount of the transfer.”

If Secretary Mnuchin intends to change that rule — i.e., to allow businesses to deduct payments to charities as business expenses — then state and local governments can make it very easy for individuals with income from “passthroughs” (partnerships and S corporations) to blunt the impact of the December 2017 tax law’s $10,000 cap on state and local tax (SALT) deductions. For example, a state could give partnerships and S corporations a dollar-for-dollar state tax credit for contributions to state-affiliated or state-chosen charities; the partnership or S corporation could claim those contributions as a section 162 business expense, which passes through to the partner or S corporation shareholder; the partnership or S corporation could then pass the state tax credits through to its partners or shareholders; and the partners or shareholders could use those credits to offset their state tax liability. Last month’s proposed regulations — which require individuals to reduce their section 170 charitable contribution deductions by any state tax credit above a de minimis amount — would not get in the way, because the partner or shareholder would never need to claim a section 170 charitable contribution deduction for donations to state tax credit programs. A section 162 business expense deduction would pass through to them, and that would be that.

Alas, this arrangement does nothing to benefit employees who run into the $10,000 SALT cap. That is because the December 2017 tax law also prohibits employees from claiming business expense deductions under section 162. (The suspension of employee business deductions runs out in 2026, which is when the $10,000 SALT cap disappears as well.) So it appears that Secretary Mnuchin has written a playbook for partners and S corporations to escape the effects of the $10,000 SALT cap but left employees high and dry.

This realization led me to ask: Who are the partners and S corporation shareholders who stand to benefit from the IRS’s purported “clarification” (which really looks more like a change in the law)? Or more precisely: Where are they? Fortunately, the IRS Statistics of Income Division makes them relatively easy to find. The IRS makes available state-level data on partnership and S corporation income, broken down by household adjusted gross income (AGI). We know that the direct effects of the SALT cap are concentrated among households earning $200,000 or more. So I calculated passthrough (i.e., partnership and S corporation) income as a percentage of total income for households with AGIs above $200,000, and put it together in a Google spreadsheet.

A few fun facts: Passthrough income as a percentage of total income among high-income households varies rather dramatically across states, from a high of 33.8% in South Dakota to a low of 8.94% in New Hampshire. Of the top 10 states (i.e., the ones in which high-income households stand to benefit the most from Mnuchin’s “clarification”), nine were states that Donald Trump won in December 2017. (The only exception is Maine.) Of the bottom 10 states (i.e., the ones in which high-income households stand to benefit the least), seven were states that swung for Hillary Clinton. Overall, a 1 percentage point increase in Trump vote share is correlated with an 0.19 percentage point increase in passthrough income as a percentage of total income for high-income households, and the p-value is 0.0003 (i.e., statistically significant by any measure).

I cannot say for sure that Secretary Mnuchin issued this so-called clarification in order to enable high-income individuals in red states who are the Republican Party’s biggest financial backers to skirt the $10,000 SALT cap while high-income individuals in blue states who earn wages on W-2s feel the bite. (But if that’s the inference you’d like to draw, be my guest.) For one thing, the $10,000 SALT cap affects beneficiaries of state and local government spending as well as payors of state and local taxes (which is one reason why I think the uncapped SALT deduction was much less regressive than its opponents made it out to be). For another, we still don’t know what effect Mnuchin’s clarification will ultimately have. Perhaps the nonpartisan civil servants at the IRS will continue to enforce the section 162 rules as they did before, thus denying business expense deductions for donations to state charitable credit programs under most circumstances. And perhaps the geographically disparate effects of Mnuchin’s clarification are mere happenstance. Concededly, I find it hard to come up with any plausible nonpolitical explanation for Wednesday’s notice. But if you can, I’m all ears.

Partnership and S Corporation Income as a Percentage of Total Income for Households with AGI ≥ $200,000 (Tax Year 2016) (By State)

1. South Dakota: 33.76%

2. Idaho: 27.44%

3. Montana: 27.12%

4. Louisiana: 25.90%

5. Maine: 25.90%

6. Utah: 24.44%

7. North Dakota: 24.13%

8. Indiana: 24.04%

9. Mississippi: 23.34%

10. Alabama: 23.30%

11. Iowa: 23.23%

12. Nebraska: 23.04%

13. Kansas: 22.45%

14. Wisconsin: 22.20%

15. Missouri: 21.11%

16. Alaska: 20.78%

17. Michigan: 20.11%

18. Oklahoma: 19.70%

19. South Carolina: 19.61%

20. Kentucky: 19.20%

21. Florida: 18.96%

22. Minnesota: 18.80%

23. Oregon: 18.78%

24. West Virginia: 18.72%

25. Ohio: 18.61%

26. Georgia: 18.11%

27. Wyoming: 18.03%

28. Nevada: 17.92%

29. North Carolina: 17.57%

30. Arizona: 17.04%

31. District of Columbia: 16.58%

32. Colorado: 16.49%

33. Delaware: 16.48%

34. New Mexico: 16.38%

35. Arkansas: 16.25%

36. Rhode Island: 15.99%

37. Vermont: 15.84%

38. Maryland: 15.79%

39. Virginia: 15.24%

40. Illinois: 14.67%

41. New York: 14.66%

42. Texas: 14.58%

43. Massachusetts: 14.26%

44. California: 14.18%

45. Pennsylvania: 14.05%

46. Hawaii: 13.66%

47. New Jersey: 13.59%

48. Washington: 13.52%

49. Connecticut: 13.10%

50. Tennessee: 12.91%

51. New Hampshire: 8.94%

Whatever Source Derived

Thoughts on tax and the law

Written by

Assistant Professor; UChicago Law; teaching tax, administrative law, and torts

Thoughts on tax and the law

Welcome to a place where words matter. On Medium, smart voices and original ideas take center stage - with no ads in sight. Watch
Follow all the topics you care about, and we’ll deliver the best stories for you to your homepage and inbox. Explore
Get unlimited access to the best stories on Medium — and support writers while you’re at it. Just $5/month. Upgrade