IRS Issues Notice for Pass-Through Entity SALT-Cap Workarounds
By: Tony Konkol and Cathy Stanton
You probably wouldn’t call it love at first sight, but the IRS seems to be warming up to the pass-through entity SALT cap workarounds that have been enacted in a handful of states in the wake of federal tax reform.
In Notice 2020-75, released November 9, the IRS announced that proposed regulations will be issued to explain the manner in which state taxes imposed on pass-through entities (“PTEs”) at the entity level can be deducted by the PTE in computing its non-separately stated taxable income or loss for the tax year of the payment. The proposed regulations described in Notice 2020-75 will apply to “Specified Income Tax Payments” made on or after November 9, 2020, but will also permit taxpayers to apply the rules described in the notice to Specified Income Tax Payments made in a PTE’s tax year ending after December 31, 2017, and 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 federal tax reform law known as the Tax Cuts and Jobs Act (“TCJA”) established a cap on the amount of deductible state and local taxes for many individual taxpayers. Beginning in 2018, the itemized deduction for state and local taxes paid is limited to $10,000 per return for single filers, head of household filers, and married taxpayers filing jointly; the cap is $5,000 (each) for married taxpayers filing separately. As a result, taxpayers with state and local taxes that exceed the cap amount lose a deduction for the excess amounts.
However, the SALT cap established by the TCJA only applies to individuals – it does not apply to business entities. In response, several states adopted legislation that imposes an entity-level tax on PTEs such as partnerships, S-corporations, and limited liability companies. Since individual owners of PTEs report their proportionate share of business income on their individual income tax returns, the premise of these new state legislative efforts is to shift state taxes on PTE income from the individual owner back to the PTE itself.
The concept of imposing entity-level taxes on PTEs is hardly a new concept. The District of Columbia, New Hampshire, Tennessee, and Texas have assessed income or franchise taxes on PTEs for years. Since the passing of the TCJA, however, a new wave of state entity-level taxes on PTEs has emerged, motivated by an intent to circumvent the TCJA’s $10,000 SALT cap and provide relief to individual taxpayers affected by the limitation.
The trailblazer of this new wave is Connecticut, who passed a mandatory entity-level tax on PTEs in May of 2018; Wisconsin, Oklahoma, Louisiana, Rhode Island, New Jersey, and Maryland have since joined the fray with their own regimes to impose elective entity-level taxes on PTEs.
While the mechanics of each states’ entity-level tax on PTEs vary, they generally follow one of two methodologies: 1) income that is taxed at the PTE level is excluded from the owner’s state taxable income; or 2) the PTE owner’s share of distributed income is passed through in the usual fashion, but the individual owners are allowed a “credit” for the tax paid by the PTE. Within the group of seven states that have enacted SALT cap legislation, Connecticut is unique in that its entity-level tax is mandatory, and more closely resembles the entity-level taxes historically imposed by states on PTEs. In contrast, the six states that have enacted legislation since have made their entity-level PTE tax an optional election. Despite this distinction, the latest announcement by the IRS indicates that the PTE will be allowed the deduction for state taxes at the entity level regardless of whether it is optional or mandatory.
On the sidelines, around another half-dozen states have proposed legislation, or at least considered implementing their own entity-level taxes on PTEs. These states may perhaps have been discouraged from moving forward with legislative efforts to implement an entity-level PTE tax due to the looming specter of possible federal scrutiny. However, as a result of the IRS’ apparent blessing, or at least acquiescence, to recent state efforts to tax PTEs at the entity level, it is likely that we will see other states moving forward with legislation to that end in the near future.