IRS Intends to Greenlight Full State Income Tax Deduction for Pass-Throughs

On November 9, 2020, the IRS (Notice 2020-75) informed it intends to issue proposed regulations supporting the use of Pass-Through Entity (PTE) SALT Workarounds. This taxpayer-friendly development would affirm that individual owners or shareholders of a pass-through entity would not be limited in the amount of state and local tax that can be deducted.

The aftereffects of the Tax Cuts and Jobs Act (TCJA) has been the states’ attempt to circumvent the $10,000 state and local tax (SALT) deduction limitation through the use of entity-level taxes. A number of states have proposed or passed legislation that attempt to reduce the SALT limitation effects on taxpayers without reducing their own respective tax revenues. States responded by enacting various workaround bills in an effort to mitigate the impact of the limitation. Some of the SALT workarounds we have seen to date include: charitable deductions, payroll tax expense, and pass-through entity taxes. While some of the initial workarounds have had their shortcomings, the latter of PTE workarounds have gained steam as a possible workable solution.

As we wrote about in our September 2, 2020 article, “New Jersey Businesses Should Consider SALT Deduction Limitation”; New Jersey is one of the latest states to enact such SALT workaround, using an entity-level tax, known as the Pass-Through Business Alternative Income Tax (BAIT). One of the primary concerns with PTE SALT Workarounds, such as the New Jersey BAIT, has been the uncertainty if the IRS would target them.

IRC 164(a) allows for businesses to deduct state income taxes, which continue to be deductible without limitation for legal entities. This IRS taxpayer-friendly Notice explains that the agency will view PTE type taxes to be imposed on the partnership or S corporation, opposed to being imposed on the individual owner; and therefore will not be subject to limitation. Moreover, the IRS clarifies that the forthcoming proposed regulations would not make a distinction between a PTE tax which may be mandatory (e.g. Connecticut PTE Tax) versus a PTE tax made by election (e.g. New Jersey BAIT).

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The IRS notice of the forthcoming proposed regulations is certainly encouraging news. While we will continue to monitor any developments as the IRS releases further guidance on this, businesses should still continue to weigh the potential benefits along with the risks in determining the right course of action for electable PTE taxes, such as the New Jersey BAIT.

Some considerations that may need to be taken into account include resident credits for nonresident owners of a PTE. As such, nonresident owners of an entity subject to entity-level tax may not receive a credit in their home states for the entity tax paid, resulting in possible double state income taxation. Further, in states like New Jersey, nonresident owners may be subject to duplicate withholding requirements.

Author: Bonnie Susmano, JD, MBA, [email protected]