Many taxpayers in high tax states are starting to realize the high cost they pay to live in that state. In the past, the state income tax was at least deductible. No one liked paying it, but at least you got a federal tax deduction.
Starting in 2018, maximum deduction for the state income tax you pay is limited to just $10,000 per year. And the real estate tax figures into that as well. In other words, if your real estate taxes are $8,000 per year and your state income taxes are $20,000, you’re only going to be able to deduct $10,000 on your federal return.
It doesn’t matter what the source of that state income tax is, your salary, your interest, capital gains or your business that is held in a pass-through entity. If you live in that state, you pay state tax on the income that is showing on your tax return.
MYTH: There is a mis-understood tax strategy going around that says that businesses get to deduct the state taxes they pay, while individual taxpayers cannot.
The right answer is “kind of.”
An individual is limited to a federal tax deduction of $10,000 in total for state and local taxes if they itemize their deductions. A business’s taxes are calculated on the individual tax return unless the business is a C Corporation. So this myth is kind of right, but mostly wrong.
Back to the blog topic…
If you can’t get out of the state tax system with your salary, interest, etc., how about setting up a corporation in a no-tax state like Nevada?
That’s been a tried and true and tried and failed strategy for years. The issue is that first of all, you need a C Corporation. If you have a pass-through entity like an S Corporation, it all flows through to your personal return and guess what? You still pay state tax on it and that state tax may be only partially deductible.
But let’s say you have a profitable business or side business and decide you’re fine with a C Corporation. You set up a Nevada C Corporation. Now what? Well, if you take money back out of the company for your personal use, you have to pay state income tax on it. You can take tax-free benefits, where applicable. You can take a salary, but that will taxable for your home state. You can take dividends, but that’s the worst possible answer (double taxation). Or you can take loans and if they are personal, and then risk the wrath of the IRS.
The best plan is to figure that the money stays out of state.
But that’s not your only issue. You also have to prove that there is a good business purpose for the whole business set-up (more than just tax savings) and that you truly have a connection in the other state.
For many people, that won’t work. If it does for you, make sure you properly set up and manage your C Corporation. And, verify that you don’t inadvertently end up with another state issue. For example, California says that if you have 25% of your gross receipts from California residents then you have to file a CA return for at least part of the income.