by Andreas Petrou, CPA and Svetlana Romano
There is some great news in the world of taxation for small businesses. As of November 9, 2020, the IRS released guidance (Notice 2020-75) which agrees that pass-through entity (PTE) businesses can claim entity-level deductions for state income tax paid under state laws. This results in shifting the tax liability from an individual to the business entity.
Background
As a part of the Tax Cut and Jobs Act (TCJA) of December 2017, a limitation of $10,000 was placed on the state and local tax (SALT) deductions of individuals who itemize their deductions on Schedule A. This limitation is effective for tax years 2018 and beyond. Previously, there was no limitation on the amount of allowable SALT that could be deducted. Residents of high-income tax states like California, New Jersey, Massachusetts, Maryland, New York, Connecticut, Illinois, and the District of Columbia, were most impacted. This limitation highly impacts Americans in the middle and upper-middle classes, especially those who are homeowners with substantial property tax bills. The result was a substantially increased federal tax liability.
Due to the fact that New Jersey is one of the high-tax states, its residents were left with a higher tax bill after the new law took an effect in 2018. The Garden State, which is known for having the highest average property taxes in the nation, continued to fight against the Federal law changes. In 2019, the New Jersey Attorney General teamed up with the Attorney Generals of New York and Connecticut to file a lawsuit in order to challenge the new IRS rules, arguing that the change had an unfair impact on their constituents.
Connecticut, Louisiana, Maryland, New Jersey, Oklahoma, Rhode Island, and Wisconsin have all adopted entity-level taxes which offer credits against the owners’ personal tax liability. These states have their own rules. With the IRS guidance approving the workaround we anticipate more states to adopt similar measures.
New Jersey
This new guidance allows entities with nexus in NJ (i.e. pass-through entities) to make an election to become subject to an entity-level income tax. Business owners who take advantage of this election will be able to receive a refundable credit against their NJ individual gross income and/or corporate business tax. The federal deduction for the state tax would be claimed at the company level on the business return, making the owners eligible to receive a state credit on their personal tax returns for their pro rate share. The income tax will be calculated first at the company level based on the rates listed below. The tax will reduce the owners’ share of federal taxable income from the entity but will not reduce the tax liability below the statutory minimum tax. Members then will need to report their pro rata share of PTE income (unreduced) on their NJ return. Lastly, the members will be able to claim their pro rata share of tax paid at the entity level as a credit against their NJ Tax Return. If the election is made, the tax will be calculated based on the business owner’s share of distributive proceeds. Per the NJ Division of Taxation, “Distributive Proceeds” is defined as; “Distributive proceeds” means the net income, dividends, royalties, interest, rents, guaranteed payments, and gains of a pass-through entity, derived from or connected with sources within New Jersey.
The Tax rates to be used to calculate the NJ pass-through entity income tax are as follows:
- 5.675% of the sum of proceeds not over $250,000
- $14,187.50 plus 6.52% of the proceeds over $250,000, but not over $1,000,000
- $63,087.50 plus 9.12% of the proceeds over $1,000,000, but not over $5,000,000
- $427,887.50, plus 10.9% of the excess over $5,000,000
This election is available to pass-through entities (i.e. S-Corporations, Partnerships, and Limited Liability Companies) beginning January 1, 2020. The election must be made annually and is not allowed to be done retroactively. This means that if the election is missed, an amended return cannot be filed to correct for the missed election.
Since 2020 is the first year the PTE tax is available, taxpayers will not be penalized under the safe harbor provisions for failure to file or make estimated payments this year.
Connecticut
Connecticut has a mandatory PTE tax. There are two options for calculating income: the “standard base method” or the “alternative tax base method.” The PTE tax is 6.99%, the same as Connecticut’s top individual income tax rate, under both income calculation methods. Owners receive an offsetting credit based on the percentage of the owner’s direct and indirect share of the PTE tax, provided that the tax has already been paid. For tax years that begin in 2019 or thereafter, the tax credit percentage is 87.5%.
Louisiana
Louisiana enacted an optional passthrough entity tax, effective for tax years beginning on or after Jan. 1, 2019. The passthrough entity is taxed based on a graduated rate structure. To make the election, owners holding more than 50% of the ownership interests in the passthrough entity, which is based on capital account balances, and must approve the election. The passthrough entity election remains effective for future tax years, until it is terminated. The owners of an electing passthrough entity exclude their share of net income or loss from their Louisiana individual tax returns instead of a tax credit for their share of the Louisiana passthrough entity tax.
Maryland
Maryland is the most recent state to enact a PTE tax election. Maryland’s election is similar to the rules enacted by New Jersey and Rhode Island. If the PTE tax election is made, both corporate and individual members will receive a corresponding and refundable Maryland state income tax credit, as well as a Maryland county tax credit, based on their share of the Maryland PTE tax that was paid by the entity. A member must include their distributive share of PTE income in their Maryland income tax base and calculate their corresponding Maryland income tax but may use the pass-through tax credit to offset their Maryland individual or corporate tax liability. The highest marginal state individual tax rate is 5.75%, and the lowest county individual tax rate is 2.25%, for a total of 8.0%.
Oklahoma
Oklahoma’s election is available for tax years beginning on or after Jan. 1, 2019. For tax years beginning on or after Jan. 1, 2020, the election must be made within two months and 15 days after the close of the tax year. Oklahoma allows a PTE to choose to be taxed at a 5% rate on the distributive share of Oklahoma net entity income allocable to individuals. Similar to Maryland, the election is binding and will stay in effect until terminated by the PTE but may also be terminated by the state if the tax is not paid.
Rhode Island
An eligible pass-through entity may elect to pay Rhode Island state income tax at the entity level at a rate of 5.99%. The Company is paying the entity-level tax on behalf of both its resident and nonresident owners when the election is made. The election, like New Jersey, is to be made on an annual basis. Also, a PTE tax imposed by another state on the owners’ income is allowed as a credit for taxes paid to another jurisdiction.
Wisconsin
Wisconsin was the first state to enact an elective passthrough entity tax in 2018. Wisconsin allows PTE’s to elect to pay income tax at a rate of 7.9%, equal to Wisconsin’s corporate income tax rate. No tax credits can be claimed against the PTE, except for the credit for tax paid to other states. Like Louisiana, the PTE partner or shareholder will exclude their proportionate share of the entity’s distributive income from their Wisconsin adjusted gross income.
Final Thoughts
As a part of the Tax Cut and Jobs Act (TCJA) of December 2017, a limitation of $10,000 was placed on the state and local tax (SALT) deductions of individuals who itemize their deductions on Schedule A. This limitation is effective for tax years 2018 and beyond. Previously, there was no limitation on the amount of allowable SALT that could be deducted. Residents of high-income tax states like California, New Jersey, Massachusetts, Maryland, New York, Connecticut, Illinois, and the District of Columbia, were most impacted. This limitation highly impacts Americans in the middle and upper-middle classes, especially those who are homeowners with substantial property tax bills. The result was a substantially increased federal tax liability.
Due to the fact that New Jersey is one of the high-tax states, its residents were left with a higher tax bill after the new law took an effect in 2018. The Garden State, which is known for having the highest average property taxes in the nation, continued to fight against the Federal law changes. In 2019, the New Jersey Attorney General teamed up with the Attorney Generals of New York and Connecticut to file a lawsuit in order to challenge the new IRS rules, arguing that the change had an unfair impact on their constituents.
Connecticut, Louisiana, Maryland, New Jersey, Oklahoma, Rhode Island, and Wisconsin have all adopted entity-level taxes which offer credits against the owners’ personal tax liability. These states have their own rules. With the IRS guidance approving the workaround we anticipate more states to adopt similar measures.
If you have any questions on how this impacts you or your business, please click HERE to contact us.
