The IRS issued guidance allowing individual owners of pass-through entities, such as partnerships and S corporations, to deduct an unlimited amount of certain taxes on income earned from pass-through entities that would otherwise be limited to $10,000.
State and local tax (SALT) deductibility
The TCJA imposed a $10,000 limit on the deductibility of SALT payments made by or on behalf of individual taxpayers. This significantly curtailed the itemized deductions of many taxpayers, particularly those with business income from pass-through entities who generally pay state income tax on that income at the individual level. Since that limitation took effect in 2018, many states have attempted to create legislative or administrative options that would enable individuals to pay state taxes in a manner that would qualify for full deductibility at the federal level.
One option allows pass-through entities to pay income tax at the entity level, rather than at the individual level. Because the federal limit on SALT deductibility only applies to individuals, the pass-through pays the tax at the entity level and treats it as an expense that it deducts from the income earned by the partners or shareholders. A number of states, including New Jersey and Wisconsin, have enacted tax regimes intended to shift the burden of the income tax liability from the individual owners to the pass-through entity in an attempt to preserve the full federal income tax deduction for state taxes.
IRS Notice 2020-75 indicates that pass-through entities will be permitted to deduct certain entity-level income tax payments. As a result of this Notice, the creation of entity-level tax schemes on pass-through entities may be a viable workaround of the $10,000 deduction limit for state and local taxes created by the TCJA. We anticipate that other states will adopt similar legislation to provide pass-through entities with an election to pay state income tax in lieu of owners paying the tax, especially since these laws are designed to not negatively impact state revenue.
IRS guidance on SALT deductibility for pass-throughs
The IRS stated recently that it intends to issue proposed regulations to clarify that partnerships and S corporations are allowed to deduct certain state and local income tax payments at the entity level for federal income tax purposes. This will permit the entity to reduce the amount of taxable income that it distributes to its owners, in effect allowing each owner’s taxable income from the entity to be reduced by his or her share of the full amount of certain state and local taxes paid. The Notice indicates that the forthcoming proposed regulations will apply to any tax payments made by a pass-through entity for any year ending in 2018 or later.
The IRS stated recently that it intends to issue proposed regulations to clarify that partnerships and S corporations are allowed to deduct certain state and local income tax.
Many questions remain
This notice generally amounts to good news for individuals who receive income from pass-through entities, but the guidance provided still leaves many questions unanswered. Perhaps the most significant of these is, “Does every state income tax imposed at the entity level on a pass-through qualify for deduction from the entity’s federal income?” Based on the notice’s description of the types of state tax payments that will qualify, it’s possible some existing state laws will not result in taxes that will be deductible at the federal level.
While taxpayers are permitted to rely on guidance in the notice, it’s also still very early in the process to assume the current definitions won’t change. If you have pass-through income subject to tax in an affected state, you will need to work closely with your tax advisor to determine how to apply the most recent guidance available to your specific facts and circumstances.
There are other considerations before electing to pay income tax at the pass-through-entity level. One significant consideration is whether individual owners who are residents of states that impose income taxes are eligible for a credit for taxes paid to other states. Shifting the tax liability to the entity for these individuals may remove their ability to claim a credit for taxes paid to other states, inadvertently increasing the tax liability in their home state. This isn’t an issue for individual owners who are residents of states with pass-through entity tax elections, and the pass-through entity only files an income tax return in that individual’s state of residency. Further, this isn’t an issue for individual owners who are residents of states that don’t impose a tax on net income from a pass-through entity, such as Florida, Tennessee, Texas, and Washington.
If you have pass-through income subject to tax in an affected state, you will need to work closely with your tax advisor.
Additionally, whether or not the entity-level tax rate is higher than the individual tax rate, must be considered in determining if there is a material difference in the amount of state tax if such elections are made.
Based on the IRS guidance, it doesn’t generally appear that taxes paid on state tax composite returns and nonresident income tax withholding qualify for a pass-through entity income tax deduction. However, further analysis is required to determine each state’s treatment.
If you have any questions about the effect of this notice on income that you receive from a pass-through entity, please contact your Plante Moran advisor.