Internal Revenue Service agrees to the Deductibility of Certain State payments made by Pass through Entities (Partnerships and S corporations)
Background
The Tax Cuts and Jobs Act that was passed into law on December 2017, effective for tax years commencing thereafter, limited the individual itemized State and local tax deduction (income, real estate taxes, etc.) on the Federal individual income tax return to an amount not exceeding $10,000; SALT limitation. For example, if an individual taxpayer has incurred $10,000 in real estate taxes and $15,000 in State income tax on income earned, the maximum the taxpayer can deduct as an itemized deduction is $10,000 and the balance is lost as a deduction. Various states have developed a workaround to mitigate the lost deduction and resulting tax benefit.
On January 13, 2020, Governor Phil Murphy signed Senate Bill No. 3246 (S3246), Pass-through Business Alternative Income Tax Act into law, BAIT. The Bill establishes a new elective pass-through business alternative income tax with a corresponding income tax credit for members and applies to taxable years beginning on or after January 1, 2020.
For a Pass-Through Entity, PTE, to make an election, the members of the PTE (at the time the election is filed) must execute consent under penalties of perjury. The PTE election must be made annually on or before the due date of the entity’s return. PTEs are allowed to revoke an election until the due date of the return for that tax year
Tax Rate
The PTE tax is imposed on total distributive proceeds, which is the sum of each member’s share of distributive proceeds, at the following rates for taxable years beginning on or after January 1, 2020:
5.675 percent, if the distributive proceeds of the PTE are less than or equal to $250,000 in the taxable year,
$14,187.50 plus 6.52 percent of the distributive proceeds greater than $250,000, but not over $1,000,000, in the taxable year,
$63,087.50 plus 9.12 percent of the distributive proceeds greater than $1,000,000, but not over $5,000,000, in the taxable year, or
$427,887.50 plus 10.9 percent of distributive proceeds greater than $5,000,000 in the taxable year.
Filing and payment requirements
Electing PTEs are required to file an entity tax return and make payments on or before the 15th day of the third month following the entity’s taxable year for federal income tax purposes. Electing PTEs are required to make estimated PTE tax payments on or before the 15th day of the fourth, sixth, and ninth month of the taxable year, plus the first month succeeding the end of the tax year. In addition to entity-level filing requirements, PTEs must also report a member’s share of distributive proceeds to its members.
Tax credit for members
The bill provides a refundable tax credit for members of an electing PTE subject to New Jersey gross income tax, such as individuals, which is equal to the member’s pro-rata share of the PTE tax for that period. The legislation specifies that any credit is only available “after the application of all other credits allowed by law [. . .] and claimed by the taxpayer in the taxable year.” If the amount of credit is bigger than that of the tax otherwise due, then the excess amount of credit over tax will generally trigger an overpayment (i.e., refund). A trust or estate which receives the credit can allocate the credit to beneficiaries or use it against their tax liabilities.
The Internal Revenue Response
The IRS has now released guidance as of Monday, November 11, 2020, that proposed regulations will be released shortly which will allow pass-through entities, partnerships, and S corporations, to deduct state and local income taxes imposed on the entity. This development resolves an issue that has been around since Connecticut enacted the first pass-through tax following the passage of the Tax Cuts and Jobs Act.
In the announcement, the IRS indicated that the forthcoming regulations would treat these types of State tax payments as deductible, thereby reducing the federal income passed through to the owners. This announcement is a welcomed clarification from the IRS and will alleviate much of the uncertainty surrounding these SALT Cap workarounds that are enacted by certain states and may result in the introduction of similar tax regimes by other states.
The proposed regulations described in this notice will apply to Specified Income Tax Payments made on or after November 9, 2020. Before the issuance of the proposed regulations, taxpayers may rely on the provisions of the notice.
Conclusion
This action by the Internal Revenue Service may mitigate the effect of the Tax Cuts and Jobs Act, relating to State tax deductions for taxpayers that are members of pass-through entities. Individual taxpayers with Schedule C’s and one owner LLC’s with W2 wage earners that are not members of a pass-through entity are not affected by the change. Each taxpayer must evaluate their individual tax situation as to the benefit if any.