The IRS intends to issue proposed regulations to permit a partnership or an S corporation to deduct specified income tax payments made to a domestic state or local jurisdiction.
In Notice 2020-75, the IRS clarifies that state and local income taxes imposed on and paid by a partnership or S corporation with respect to 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, and are not subject to the state and local tax deduction limitation for partners and shareholders who itemize deductions.
This workaround to the state and local tax deduction limitation will provide a benefit to partners and S corporation shareholders in states that impose an entity-level tax on partnerships and S corporations. This is done by treating payments of those items by the pass-thru entity as a deduction by the entity thereby reducing taxable income of the partnership or S corporation that ultimately flow to the partners or S corporation shareholders.
State and Local Tax Deduction Limitation
The 2017 Tax Cuts and Jobs Act added Section 164(b)(6) which limits an individual’s deduction to $10,000 for the aggregate amount of the following state and local taxes (SALT) paid during the calendar year:
- real property taxes
- personal property taxes
- income, war profits, and excess profits taxes
- general sales taxes
The SALT Deduction Limitation – which applies for taxable years beginning after December 31, 2017 and before January 1, 2026 – significantly impacts individual taxpayers who itemize deductions in states where income, property and sales tax rates are higher.
In an attempt to relieve taxpayers of the undue burden associated with the SALT Deduction Limitation, the IRS published Notice 2020-75 which permits partnerships and S corporations to deduct state and local income taxes imposed on the partnership or S corporation.
The Notice provides that a partnership or S corporation will be permitted to claim the deduction for state and local income taxes regardless of whether the state gives a full or partial tax credit, deduction or exclusion to a partner or S corporation shareholder and regardless of whether the state entity-level tax is mandatory or elective.
The Notice provides that the proposed regulations will apply to specified income tax payments made on or after November 9, 2020. The notice also provides that the proposed regulations will permit a deduction for specified income tax payments made by a partnership or S corporation for taxable years ending after December 31, 2017 and before November 9, 2020 provided that the income tax payment is made to satisfy a state and local tax liability imposed on the partnership or S corporation pursuant to a state law enacted before November 9, 2020.
State Entity-Level Taxes
Currently, six states have enacted an entity-level tax on partnerships or S corporations: Connecticut, Louisiana, New Jersey, Oklahoma, Rhode Island and Wisconsin. Connecticut is the only state that provides for a mandatory entity-level tax, while the remaining five provide for an elective entity-level tax.
For example, New Jersey recently enacted the Business Alternative Income Tax (BAIT), which is an elective entity-level tax on partnerships and S corporations. If a New Jersey S corporation elects to have the BAIT apply, then the S corporation would pay tax at the entity level and according to Notice 2020-75 the S corporation would be able to claim a deduction for the entity-level tax. The federal income tax deduction for the New Jersey BAIT taken at the S corporation level would reduce the S corporation’s net income that would ultimately flow through to the shareholders, thus permitting the shareholders to work around the $10,000 SALT Deduction Limitation and ultimately receive a tax benefit.
Businesses in states that provide for an election to tax a partnership or S corporation at the entity level should consider whether to make such an election to take advantage of Notice 2020-75 and the forthcoming proposed regulations.