NJ Enacts New SALT Workaround with Entity-Level Tax Election

Posted on Thu, Jan 30, 2020 ©2020 Drucker & Scaccetti

DAN MARQUES - OFFICIAL - 2016By: Dan Marques, CPA, MT

 

If at first you don’t succeed, try again.  That appears to be the moto of the NJ Legislature after passing the Pass-Through Business Alternative Income Tax Act (the Act), signed into law by Governor Murphy on January 13, 2020. This is the state’s second attempt to circumvent the $10,000 federal cap on state and local tax (SALT) deductions imposed by the Tax Cuts and Jobs Act (TCJA).

 

A trip down memory lane

Some may recall NJ’s first attempt to address the SALT cap in May 2018, which called for towns, counties and school districts to set up charitable funds for taxpayers to make contributions in exchange for property tax credits. Under this program, individuals could satisfy their property tax liabilities and receive charitable deductions, which are not subject to the $10,000 federal SALT cap.

 

At the time, other states had similar programs in effect whereby charitable contributions could be made to state-organized funds in exchange for state-level tax credits.  However, many of these programs were setup before the enactment of the TCJA to address government funding shortfalls for certain programs and were not primarily designed to provide residents with tax benefits.

 

This distinction proved critical as Treasury ultimately finalized regulations in June 2019, which put the kibosh on these programs by asserting "donative intent," a requirement for federally deductible charitable contributions, did not exist under these programs.

 

How is this Act different?

While NJ's previous program intended to convert SALT deductions into charitable deductions, this program attempts to convert individual SALT deductions into fully deductible business taxes.

 

For tax years beginning on or after 1/1/2020, pass-through businesses (S-Corporations and partnerships) may elect to pay an entity-level tax to NJ.  This "alternative business tax" would reduce the owners' share of federal taxable income from the entity and would be allowed as a refundable credit against the owners' NJ tax liabilities (avoiding double-taxation in NJ).

 

The refundable credit is great, but how does this avoid the SALT cap?

It’s important to remember the SALT cap only applies to individuals.  The Act imposes a tax assessed on, and paid by, a business.  Generally, when a business pays a tax, the payment is considered an ordinary and necessary business expense fully deductible by the business.  Since the tax is not assessed and paid by the individual, the SALT cap doesn’t apply.

 

This is great, what should I do?

First, you need to review your company's operating agreement and determine who makes decisions on behalf of your company.  These decision-makers must elect annually, on or before the due date of the company's tax return, whether to apply the entity-level NJ business tax. If the election to pay the entity-level tax is made, the income of the company will be subject to the tax as described later. Accordingly, it may be prudent to discuss this election among the company's ownership group as there may be adverse consequences to some owners based on their individual tax situations. It's possible your company's legal counsel may need to be consulted if there are conflicts.

 

Second, during the preparation of the company's tax return, the entity-level tax (if elected) will be calculated based on the company's distributive proceeds (a defined term akin to NJ-source income).  The company’s total distributive proceeds will be taxed based on graduated rates between 5.525% and 10.75%.

 

The company will submit the tax payment with its NJ tax return or extension. The Act also imposes quarterly estimated tax payments for businesses that anticipate making the election in the following year, so consider this in your company's cash-flow projections.

 

The company's tax will be allocated between the owners in proportion to their distributive proceeds and reported to them on their NJ Schedule K-1.  When the owner files their NJ tax return, the owner will use the allocated tax information to claim a credit against their NJ tax liability.  It’s important to note the credit is refundable; meaning if the tax paid by the business exceeds the tax owed on the owner’s tax return, the excess can be refunded.

 

All in all, the NJ income tax burden is shifted from the company's owners to the company and an otherwise limited individual SALT deduction is converted to a deductible business expense of the company.

 

This seems too good to be true.  Can the IRS still challenge this?

In prior guidance, the Department of Treasury indicated it may address these arrangements in future guidance.  However, other states have enacted (Connecticut) or are considering (Arkansas and Wisconsin) making similar changes to their tax structure.  Removing the charitable component from the equation improves the legal standing of these types of programs. As with all tax-saving strategies, there is always some level of risk involved.

 

The Tax Warriors® at Drucker & Scaccetti can help you determine whether this election may be beneficial to you or your business. As with all tax law, there are nuances and exceptions that may be significant if applicable and the application to multi-tier entities may be complex. Contact us if you need assistance.

 

Topics: charitable contributions, Property Taxes, Connecticut, charitable deductions, New Jersey, SALT deduction, business taxes, SALT Workaround, Donative intent, Pass-Through Business Alternative Income Tax Act, $10,000 cap, Local tax cap, Arkansas, Wisconsin, entity-level tax, state and local taxes

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