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IRS to Bless the Entity Level State Tax Workaround to the SALT Cap

The IRS has blessed the entity level state tax workaround that was employed by some states in response to the state and local tax deduction cap.

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The IRS has blessed the entity level state tax workaround that was employed by some states in response to the state and local tax deduction cap.

The IRS released Notice 2020-75, which announces Treasury’s intent to issue proposed regulations to clarify that the state and local income taxes imposed on and paid by a partnership or an S corporation on its income are allowed as a deduction by the partnership or S corporation in computing its non-separately stated taxable income or loss for the taxable year of payment. In other words, the IRS has blessed the entity level state tax workaround that was employed by some states in response to the state and local tax (SALT) deduction cap. This cap, imposed by the 2017 Tax Cuts and Jobs Act (TCJA), limited an individual’s deduction for state and local income taxes to $10,000.

This means that states that adopted entity level pass-through entity taxes in response to TCJA can now rest assured that they will not be challenged by Treasury. Examples of state taxes that seem to fall within the acceptable definitions in this notice are the Connecticut Pass-through Entity Tax and the Rhode Island Pass-through Entity Election Tax.

This notice is consistent with the position that most professionals have been taking by deducting the entity level state tax expenses as an above-the-line expense. However, this notice provides additional comfort to taxpayers that Treasury will not challenge the treatment of these entity level state tax deductions.

Insights from the blumshapiro State and Local Tax Experts

Connecticut

For tax years beginning on or after January 1, 2018, Connecticut was the first state in the country to enact a mandatory pass-through entity income tax (PET) in response to the TCJA individual taxpayer itemized deduction SALT (i.e., state and local tax) cap.

The PET is imposed on the Connecticut taxable income of the pass-through entity at the highest personal income tax rate of 6.99%. In essence, the goal of the PET is to push the Connecticut income tax deduction from the owner down into the pass-through entity business, thus allowing the pass-through entity owner a federal income tax benefit from the state income tax deduction (via a reduced distributive share of non-separately stated ordinary income), circumventing the $10,000 SALT cap.

Because the pass-through entity’s distributive share of income will be subject to Connecticut personal income taxation again (through the taxation of an individual owner’s adjusted gross income (AGI)), to mitigate double Connecticut income taxation on the same income, a tax credit is allowed to the owner to reduce their Connecticut income tax liability.

Through the Notice and anticipated formalized regulation, the IRS has acquiesced to Connecticut’s mandatory regime and has essentially ignored the credit mechanism for the owner to avoid double taxation. Connecticut owners of pass-through entities doing business in Connecticut should be able to rest comfortably knowing that the federal government will not attack Connecticut’s PET methodology.

Rhode Island

Rhode Island enacted similar PET legislation for tax years beginning on or after January 1, 2019. However, its PET is elective at the pass-through entity level and the mechanism to avoid double taxation is calculated differently.

Pass-through entities are allowed to elect to pay an entity-level Rhode Island income tax on net income at the highest personal income tax rate of 5.99%. The amount of Rhode Island entity-level tax that reduces federal net income is included by pass-through entity owners as a Rhode Island addback modification in calculating their respective Adjusted Rhode Island Taxable Income. After the Rhode Island tax liability is determined, each pass-through entity owner receives a Rhode Island personal income tax credit equal to 100% of their respective share of the Rhode Island income tax imposed on the pass-through entity.

Like Connecticut, the IRS has acquiesced to Rhode Island’s PET, albeit it is elective. Rhode Island taxpayers who did not elect the pass-through entity tax regime for 2019 because they had concerns about the sustainability of Rhode Island’s PET should now consider making the election for subsequent tax years.

Other States

Other states such as Louisiana, New Jersey, Oklahoma and Wisconsin have enacted similar elective regimes. With Treasury’s and IRS’s “blessing,” there should generally be no reason not to elect into their PET regimes.

In addition, with Treasury’s and the IRS’s favorable attitude toward the “workaround,” states, like New York who tinkered with the idea, should have the impetus to enact either mandatory or elective PETs to provide federal income tax relief to their business owner constituents.

 

Disclaimer: Any written tax content, comments, or advice contained in this article is limited to the matters specifically set forth herein. Such content, comments, or advice may be based on tax statutes, regulations, and administrative and judicial interpretations thereof and we have no obligation to update any content, comments or advice for retroactive or prospective changes to such authorities. This communication is not intended to address the potential application of penalties and interest, for which the taxpayer is responsible, that may be imposed for non-compliance with tax law.

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