By: Jonathan S. Kandel, CPA and Clare Porreca, CPA, MT
On November 9, 2020, the IRS released Notice 2020-75 announcing proposed regulations will be issued confirming that state and local taxes imposed on and paid by a partnership or S Corporation will be 100% deductible by the entity, and thus not limited to the $10,000 limit on state and local tax (SALT) deductions.
The Tax Cuts and Jobs Act (TCJA) limited the state and local tax deduction for individual taxpayers to $10,000 for tax years 2018 – 2025. Since the enactment of the TCJA, several states have tried to create various workarounds to the SALT cap, including converting state and local taxes to charitable contributions through donations to specific state-run charitable organizations. The IRS previously provided guidance disallowing these specific charitable deduction workarounds.
The Pass-through Entity Tax Workaround
Another workaround some states considered involves enacting entity-level taxes for pass-through entities whereby the entity pays tax instead of its owners and then deducts the full amount of state taxes paid, thus avoiding the $10,000 SALT cap at the individual level. IRS Notice 2020-75 endorses this pass-through entity tax workaround creating a viable option for taxpayers who own pass-through entities to receive a tax benefit for some of their state and local taxes paid greater than $10,000.
Seven states have created entity-level taxes for pass-through entities:
- New Jersey
- Rhode Island
The entity-level tax in all these states, except for CT, is elective; CT’s entity-level tax is mandatory.
With state legislatures busy trying to balance budgets decimated by the COVID-19 pandemic, the IRS may have just delivered an early holiday gift of potential increased tax revenues. States that implement similar pass-through SALT workarounds could raise revenue due to higher entity-level tax rates while simultaneously benefiting constituent taxpayers by potentially lowering their net SALT tax cost after federal deductions. This would be an economic win for all involved if the numbers work out.
As with most tax elections, an analysis should be done to calculate the tax savings or costs. Taxpayers filing in states with pass-through SALT workarounds will need to ensure the benefit received from the full SALT deduction outweigh higher entity-level tax rates versus individual owner-level rates.
We blogged about this issue earlier this year when NJ enacted its pass-through SALT workaround. In that blog we outlined next steps for impacted taxpayers. Many of the same steps apply to taxpayers filing in other states with elective entity-level taxes.
As with all tax law, there are nuances and exceptions that are complex and could significantly impact your decision to make an election to be taxed at an entity level. The Tax Warriors® at Drucker & Scaccetti can help you determine whether these state elections may be beneficial to you and your business. Contact us if you need help analyzing the tax implications of electing entity-level SALT workarounds for your pass-through entity and read more about our multi-state tax compliance and consulting services here.