On November 9, 2020, the Internal Revenue Service (“IRS”) issued Notice 2020-75 (“Notice”), which announced that proposed regulations will be forthcoming, clarifying the deductibility of “state and local income taxes imposed on and paid by a partnership or an S corporation” (collectively, “Pass-Through Entities” or “PTEs”) on its non-separately stated taxable income or loss for the tax year of the payment. The Notice comes on the heels of several states’ responses to the limitation on the deductibility of state and local taxes (the “SALT Cap”), which was enacted as part of the Tax Cuts and Jobs Act (“TCJA”), that seek to afford relief to its residents from this limitation.
Applicable to tax years beginning on or after December 31, 2017 through December 31, 2025, the TCJA introduced a $10,000 limit on the deduction for state and local taxes paid by individual taxpayers who itemize their deductions. The new limitation imposed by the SALT cap affected several individual taxpayers, including owners of PTEs, especially those living in high-tax jurisdictions (i.e., New York, New Jersey and Connecticut), causing many to experience an increase in their federal taxable income, as compared to pre-TCJA tax years, given that state and local income taxes were no longer fully deductible.
As a result of the SALT Cap, several states have recently enacted statutes that provide an election for owners of PTEs to pay income tax at the pass-through entity level. Generally, these elections allow PTEs an option to elect to pay an entity-level income tax in lieu of pass-through treatment. Presently, the states of Connecticut , Louisiana, Maryland, New Jersey, Oklahoma, Rhode Island and Wisconsin have enacted new laws providing an option for an entity-level tax. Other state and local jurisdictions, namely the District of Columbia, New Hampshire, New York City, Tennessee and Texas, have historically imposed entity-level income or franchise taxes, as well. Nonetheless, the impact and reporting requirements of the new PTE taxing regimes in these jurisdictions vary, and further guidance is still needed (and expected to be forthcoming). However, these new taxing schemes generally take the following approach:
- The states of Louisiana, Oklahoma and Wisconsin generally require an electing PTE to calculate its tax base and pay state income tax. The PTE owner, on the other hand, is not taxable on, and does not include, a distributive share of income or loss of their personal income tax returns in these states if the PTE tax election is made.
- The new PTE elections in the states of Maryland, New Jersey, Rhode Island and Connecticut generally require an electing PTE to calculate its tax base and pay a state income tax, but retain certain pass-through features, including a state tax credit for use by owners when filing and paying their state personal income tax.
While the Treasury and the IRS intend to issue proposed regulations to clarify that state and local income taxes imposed on and paid by PTEs on its income are allowed a deduction in computing its non-separately state taxable income, the Notice does provide immediate actionable guidance that may be relied upon by taxpayers.
Specifically, the IRS’ guidance provides that “specified income tax payments” made by a partnership or an S corporation to a state, a political subdivision of a state, or the District of Columbia includes any amount paid by such PTE “to satisfy its liability for income taxes imposed by the Domestic Jurisdiction on the partnership or the S corporation.” Furthermore, the specified income tax payments will include any amount paid by such PTE, regardless of whether the entity-level tax was paid as a result of an election by either the PTE or the PTE owners, or whether the PTE owners receive a full or partial deduction, exclusion or credit when filing their own state personal income tax return.
Given that the PTE will be allowed a deduction in the tax year in which the specified income tax payment is made, the $10,000 SALT cap limitation is not likely to apply to such payments, which will be reflected in the PTE owners’ distributive or pro-rata share of non-separately state income.
Although additional guidance may be reasonably expected from the IRS, the proposed regulations, as specified in the Notice, are applicable to any specified income tax payments made on or after November 9, 2020. Furthermore, taxpayers may also apply the guidance provided in the Notice for any specified income tax payments made in a taxable year of the PTE ending after December 31, 2017 and made before November 9, 2020, “provided that the specified income tax payment is made to satisfy the liability for income tax imposed on the [PTE] pursuant to a law enacted prior to November 9, 2020.”
- The IRS’ new guidance should cause a sigh of relief for many individual taxpayers, especially those living in Connecticut and New Jersey. While many states, including New York, have not adopted similar elective PTE taxing schemes, given the additional clarity, we may expect to see more states consider adopting pass-through entity level taxes.
- Although the Notice provides guidance for federal income tax purposes, as discussed above, there are still many questions yet to be resolved, including state-specific issues related to the need for state add-back adjustments for non-deductible state income tax deductions at the PTE level, as well as how tax payments that are credited to nonresident PTE owners for individual income tax purposes in the states of Connecticut, Maryland, New Jersey and Rhode Island may be treated for purposes of available “other state taxes” credits in these PTE owners’ states of residency. 4
- Lastly, as provided in the Notice, the proposed regulations are applicable to tax years beginning on or after December 31, 2017, and therefore, taxpayers are strongly encouraged to explore whether any of the current states that have adopted a PTE tax regime have the ability to make retroactive elections, and file amended federal and state returns and refund claims.
If you have any questions regarding the applicability of the proposed regulations, please contact your State and Local Tax Team.