Since the enactment of the Tax Cuts and Jobs Act (TCJA), an individual’s federal tax deduction for state and local taxes (SALT) paid during the calendar year is limited to $10,000. The SALT limitation impacted many individual partners and shareholders. Several states responded to this limitation by issuing workarounds to enact entity-level taxes for pass-through entities where the entity pays the tax instead of its owners and then deducts the full amount of state taxes paid, thus avoiding the $10,000 limitation at the individual level. It was uncertain whether the IRS would accept this entity-level tax workaround.
The IRS released guidance on November 9 (Notice 2020-75) confirming that state and local income taxes imposed on and paid by a partnership or S corporation are allowed as a tax deduction on the pass-through entity in computing its taxable income. States that shift the tax burden from individual owners to the business entity, these tax payments are not subject to the $10,000 SALT limitation at the individual level for partners and shareholders who itemize deductions.
Seven states have created entity-level taxes for pass-through entities. Connecticut was the first state to enact the pass-through workaround and is the only mandatory entity tax. The other states are elective.
Connecticut: Connecticut’s mandatory pass-through entity tax is effective for tax years beginning on or after Jan. 1, 2018. The pass-through entity must select one of two filing methods for calculating income, the “standard base method” or the “alternative tax base method.” The pass-through entity tax is 6.99%, the same as Connecticut’s top individual income tax rate, under both income calculation methods. Effective for taxable years beginning on or after January 1, 2019, the pass-through entity tax is offset by a personal or corporate income tax credit of 87.5% (previously 93.01%).
Louisiana: For tax years beginning on or after January 1, 2019, Louisiana allows pass-through entities to elect to be taxed at the entity level and compute net income as if they filed a C-Corporation return. The tax rate is 2% on the first $25,000 of net income, 4% on the next $75,000, and 6% on the excess over $100,000. The election should be made on or before the 15th day of the fourth month after the close of the tax year (April 15th for calendar-year taxpayers). The election is binding until revoked.
Rhode Island: Effective for tax years beginning on or after January 1, 2019, a pass-through entity may annually elect to pay the Rhode Island state income tax at the entity level at the rate of 5.99% of net income. The annual election is made by filing the correct form and paying the entity level tax by the 15th day of the third month after the close of the tax year (March 15th for calendar-year taxpayers). Rhode Island is allowing a credit for taxes paid to another jurisdiction for a pass-through entity tax in that state.
Oklahoma: For tax years beginning on or after January 1, 2019, Oklahoma allows a pass-through entity to elect to be taxed at the highest marginal individual income tax rate, currently 5%. The election to become an electing pass-through entity has priority over and revokes any election to file a composite Oklahoma partnership return or pay the tax on behalf of a nonresident S corporation shareholder. The election is binding and must be made within two months and 15 days after the close of the tax year (February 15th for calendar-year taxpayers).
Maryland: Effective July 1, 2020 and applicable to all taxable years beginning after December 31, 2019, each pass-through entity in Maryland may elect to pay tax with respect to the distributive shares or pro rata shares of resident members of the pass-through entity. The tax rate for the pass-through entity is 5.75%, the same as Maryland’s highest individual income tax rate, plus 2.25% the lowest county individual income tax rate. The election is made annually by the 15th day of the third month after the close of the tax year (March 15th for calendar-year taxpayers).
New Jersey: For tax years beginning on or after January 1, 2020, pass-through entities may elect to pay tax due on the owner’s share of distributive proceeds derived or connected from sources within New Jersey. Non-corporate owner(s) may then claim a refundable tax credit for the amount of tax paid by the pass-through entity on their share of distributive proceeds. The pass-through entity tax rates are gradual ranging from 5.675% on the first $250,000 of taxable income to up to 10.9% on income above $5 million. The annual election is due by the 15th day of the fourth month after the end of the tax year (April 15th for calendar-year taxpayers).
Wisconsin: Wisconsin has enacted an optional entity level tax for tax-option S corporations and partnerships. Tax-option S corporations could begin making the election for tax years beginning on or after January 1, 2018. Partnerships could make the election to be taxed at the entity level for tax years beginning on or after January 1, 2019. Wisconsin’s entity level tax is 7.9%, equal to Wisconsin’s corporate income tax rate. Wisconsin allows a credit for tax paid to other states and the District of Columbia. The election is annual an should be made by the 15th day of the fourth month following the end of the taxable year (April 15th for calendar-year taxpayers).
While the pass-through entity tax is intended to provide a workaround to the $10,000 federal SALT deduction limitation it is important to carefully analyze whether making the election and paying the entity-level tax offers the overall lowest tax burden. There are other considerations that may make the election undesirable.
Source: Thomson Reuters Checkpoint