IRS Notice 2020-75 announced that the IRS intends to issue proposed regulations to allow state and local income taxes paid by a partnership or S corporation to be deducted in computing its taxable income or loss for the year of payment. Owners of pass-through entities will need to consider several factors when deciding whether to elect to pay state taxes at the entity-level.
“Disclaimer: This is designed to provide general information regarding the subject matter covered. It is not intended to serve as legal, tax, or other financial advice related to individual situations. Consult with your own attorney, CPA, and/or other advisors regarding your specific situation.”
Background
At the end of 2017, the Tax Cuts and Jobs Act (TCJA), P.L. 115-97 delivered the $10,000 state and local tax (SALT) deduction limitation through 2025. Prior to this change, individuals who itemized deductions could deduct their state and local tax payments in full. A number of states with higher income tax rates were disproportionately affected by this provision and quickly enacted ‘workaround’ programs.
On Nov. 9, 2020, the IRS issued Notice 2020-75 announcing its plan to propose regulations that confirm certain pass-through entity taxes (PTE taxes) are not subject to the $10,000 SALT deduction limitation imposed by the TCJA. Since then, a majority of states have now enacted PTE taxes as a workaround for the cap on the federal SALT deduction.
In theory, a basic workaround seems simple. However, the varying mechanics of each state’s workaround has created complexities for taxpayers and practitioners.
The PTE Deduction
This provision allows pass-through entities such as partnership LLCs and S Corporations to pay state taxes at the entity level, rather than at the individual level. The taxes paid are then deductible from the entity’s income.
Simple Example (Credit Mechanism)
100% owned S Corporation in Kentucky (KY) with $100,000 of pass-through income. On the S Corporation filing, the company would pay the 5% KY tax of $5,000.
Owner's KY Tax Return Results:
A $5,000 tax is created from the pass-through income, which is offset by a $5,000 credit. The KY taxes are still only paid once.
Owner's Federal Tax Return Results:
The $100,000 of pass-through income is reduced by the owner's state taxes of $5,000. Therefore, you are only taxed at the federal level on $95,000 of pass-through income. Assuming a 25% tax bracket, this saves the owner $1,250 in federal income taxes. These benefits are amplified at higher income levels and tax rates.
This is an overly simplistic example to describe how the SALT deduction benefits owners of passthrough entities for states using the credit mechanism. There are a small number of states using an exclusion mechanism that creates similar benefits, such as Louisiana and Wisconsin, that is not discussed in this article.
Partnership & S-Corporation Complications (Legal Considerations)
The considerations for the SALT tax deduction workaround includes more than financial calculations. The partnership agreement may need review to make sure certain transactions are allowed. If there is a chance that not all members will benefit from the PTE tax election, there could be a situation where members disagree on how to proceed.
There are further complications for S Corporation owners. If resident shareholders are going to get the tax credit and a side agreement is made to make a disproportionate distribution for the nonresident shareholders, this could be seen as violating the single class of stock requirement resulting in involuntary termination of S Corporation status.
Accrual Basis vs Cash Basis (Timing)
Since the deduction is included in the federal income calculation of the pass-through entity, the timing of these payments is an important consideration.
For a cash basis taxpayer, the deduction is allowed in the year they make the payment.
For an accrual basis taxpayer, all events need to have occurred to establish the fact of a liability. If making the election is what determines the liability, and that election is made upon filing the tax return in the subsequent year, then these payments may not be deductible until then. While some practitioners are recommending an update to the partnership agreement to state that the election will definitely be made, there may need to be more guidance as to whether that would satisfy the “all events” requirement.
Other Considerations
Other important factors to review when making the election include:
When can the election be made or revoked? Can the entity make a retroactive election?
Is nonresident withholding and filing still required after the election?
How is income sourced?
How are special allocations treated?
Does the PTE tax impact the section 199A deduction?
What if the business does not have trade or business income?
How are refunds reported?
Are there ASC 740 concerns with the entity-level tax? (Should the accounting treatment be a payment on behalf of the partner (equity transaction) or as an entity-level expense?)
Conclusion
More guidance is expected but for planning purposes many of the decisions will be based on how the advisor interprets the language in IRS Notice 2020-75 and the applicable state guidance. It is exciting for owners of pass-through entities to have the potential to reintroduce the SALT deduction to their tax saving strategy, but care and attention to detail is required for proper execution.
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