New Jersey has enacted legislation that gives business owners of pass-through entities a way to bypass the $10,000 limit on state and local tax deductions.

The $10,000 state and local tax limitation was implemented under federal law in the Tax Cuts and Jobs Act.[1] The law has been controversial because of its disproportionate effect on high-tax jurisdictions like New York and New Jersey.

The Pass-Through Business Alternative Income Tax Act allows pass-through entities in New Jersey, which are S corporations and partnerships (including limited liability companies that are treated as partnerships for income tax purposes), to elect to pay state income taxes at the entity level (where deductions for such taxes are not limited) instead of at the personal income tax level. The individual taxpayer (who receives the flow-through income from the business) can then claim a gross income tax credit on his or her personal New Jersey income tax return.

In effect, this allows taxpayers who qualify to reduce their federal income by the full amount of state and local taxes paid by the pass-through entity since such amount is deducted from the taxpayers’ taxable distributive share from the pass-through entity. This provides the same result as what was previously a full deduction against federal income tax for state and local taxes paid.

The legislation is effective for pass-through entities with taxable years beginning on or after Jan. 1. The law works by imposing an alternative income tax at graduated rates depending on the amount of the distributive proceeds of the pass-through entity to its owners. For instance, for 2020, if the distributive proceeds are greater than or equal to $5 million, the tax is $427,887.50 plus 10.9% of the excess over $5 million. The owner would receive a dollar for dollar credit on his or her gross income tax return.

For most, the effect of paying at a higher rate at the entity level will not make a material difference because of the offsetting credit. Nonetheless, this is something that should be considered. A second concern under the new law is that the liability for tax would now rest on the pass-through entity itself.

Under normal circumstances, one partner or shareholder would not be liable for the gross income tax liability of another partner or shareholder. Here, though, once elected, the tax liability needs to be paid by the entity (but the law also provides explicit relief to the entity for taxes of any nonconsenting owners).

It is also not uncommon for the amount of taxable distributive proceeds to exceed actual cash distributed by the entity. When the entity invests its profits back into its operations, the members or shareholders will be taxed on the phantom income. Without the election, the gross income tax liability was not a concern for the entity and the entity would not have to consider how it would be paid. With the election, the entity needs to pay the alternative income tax, which would be a new item to budget. If the entity doesn’t pay the tax, the partner or shareholder is not entitled to his or her pro rata credit.

It is estimated that the new law will save New Jersey business owners $200 to $400 million annually on their federal tax bills. Sen. Troy Singleton, D-Delran, one of the sponsors of the bill, said in a statement, “This law will help to defray the out-of-pocket income tax hit for small business owners here in New Jersey and help alleviate the inequities created by the federal tax law.”

The New Jersey Society of Certified Public Accountants assisted with the legislation. The executive director of the NJCPA, Ralph Albert Thomas, said in a statement:
We are grateful to the Governor, the Legislature and all those who supported the bill. Their dedication to assisting small businesses in New Jersey does not go unrecognized.

The new tax bill is not the first attempt to work around the $10,000 SALT deduction limit. An earlier approach in New York created a state-run charitable fund to which a taxpayer could contribute as a way of paying his or her taxes and receive tax credits in return. In New Jersey, Gov. Phil Murphy signed legislation in 2018 aimed at allowing taxpayers to convert local property tax payments into charitable contributions that could be deductible on federal tax returns.

However, the Internal Revenue Service issued regulations last year that prevent state-run charitable funds from being used in this way. At the present, there has been no federal response to the New Jersey legislation though it would not be surprising to see the U.S. Department of the Treasury issue temporary or proposed regulations to counter the new law as the law’s purpose is to allow taxpayers a workaround to avoid the SALT limitation.

In addition, New Jersey, New York and Connecticut filed a lawsuit in the U.S. District Court for the Southern District of New York to challenge the IRS regulations, which is ongoing. These three states and Maryland also filed suit in the Southern District of New York to challenge the deduction cap itself. That case was dismissed by the U.S. District Judge J. Paul Oetken but is on appeal.

The new legislation may give New Jersey business owners a reason to structure a business as a pass-through entity. For example, an entrepreneur choosing between forming a startup business as a single-member LLC, which would be disregarded for federal and state income tax purposes (and not qualify as a pass-through entity), and an S corporation which could take advantage of the new law, would have an incentive to choose the S corporation structure. Owners of other businesses that are typically organized as pass-through entities, such as law firms, accounting firms and medical practices, would also stand to gain.

Wage earners with state income and property taxes in excess of $10,000, though, have nothing to gain from the new legislation and would justifiably be frustrated by the uneven concern that the legislature has extended to some but not all heavily taxed New Jersey residents.

 

Originally published on Law360.com on January 23, 2020.

In an overwhelming 417-3 vote, the US House of Representatives passed the Setting Every Community Up for Retirement Enhancement Act (the “SECURE Act”), which has now been incorporated into a spending bill that was signed by President Trump on December 20, 2019.  While the SECURE Act includes numerous changes to certain qualified retirement plans, there is one notable change that will affect some potential beneficiaries of individual retirement accounts (“IRAs”).

Currently, when an individual reaches age 70 1/2, he or she must start taking a required minimum distribution (“RMD”) based upon his or her remaining life expectancy.  If such individual dies and leaves his or her IRA to an individual beneficiary (other than a spouse, a disabled or chronically ill person, an individual who is no more than 10 years younger than the decedent, or the minor child of the decedent), and that individual beneficiary then rolls the decedent’s IRA over to his or her own IRA (i.e. an “inherited IRA”), the RMD will be calculated on that individual beneficiary’s life expectancy resulting in a “stretch IRA.”  The stretch IRA allows for income tax-deferral and avoids a large income tax bill.

Effective January 1, 2020, under the SECURE Act, the age at which an individual must start taking RMDs is increased to age 72.  However, absent a few exceptions, while a non-spouse individual beneficiary would still be able to roll over the decedent’s IRA to his or her own inherited IRA, instead of calculating the RMD on that individual beneficiary’s life expectancy, the IRA must be distributed within 10 years of the decedent’s death.  This change could force non-spouse individual beneficiaries into higher tax brackets, resulting in higher income taxes on both such beneficiary’s ordinary income, as well as the distributions from such inherited IRA.

As an example, assume a 75 year old decedent left his or her IRA to his or her 40 year old child with a 43 year life expectancy and that the IRA is worth $1,000,000 at the time of his or her death.  Under the current law, the IRA would remain in pay-out status, but would be recalculated to be paid out over such child’s life expectancy.  Using the example, the child would receive approximately $23,256 in the first year from the inherited IRA and gradual increases over the next 42 years.  Under the SECURE Act, the child would not be required to receive any minimum distributions from the inherited IRA, but would be required to receive the entire $1,000,000 within 10 years.  Depending on the child’s income tax bracket and the investments within the IRA, the benefits that the child would have received under current law could have been considerable.

While the SECURE Act will not affect the treatment of spousal inheritance of IRAs, it is still important for all individuals to consider how these changes could impact their estate planning.  We recommend that individuals consult with their tax professionals.

 

 

On November 6, the IRS announced the official estate and gift exclusion amounts for 2020 in Revenue Procedure 2019-44.

For an estate of any decedent dying during calendar year 2020, the applicable exclusion is increased from $11.4 million to $11.58 million.  This change increases not only the applicable exclusion amount available at death, but also a taxpayer’s lifetime gift applicable exclusion amount and generation-skipping transfer exclusion amount.  This means a husband and wife with proper planning could transfer $23.16 million estate, gift and GST tax free to their children and grandchildren in 2020.   If no new tax law is passed, the increased exclusion amounts are scheduled to expire on December 31, 2025, which would mean a reduction in the exclusion amounts to $5 million (adjusted for inflation).

The estate, gift and GST tax rates remain the same at 40% and the gift tax annual exclusion remains at $15,000.

The gift tax annual exclusion to a non-citizen spouse has been increased from $154,000 to $157,000.  While gifts between spouses are unlimited if the donee spouse is a United States citizen, there are restrictions when the donee spouse is not a United States citizen.

The New York exclusion amount was changed as of April 1, 2014, and does not match the federal exclusion amount.  In 2019, the New York exclusion amount is $5.74 million.  The 2020 New York exclusion amount has not yet been released.  It is important to note that, unlike the Federal exclusion amount, the New York exclusion amount is not portable, meaning if the first spouse to die fails to utilize his or her full exclusion amount, the surviving spouse will not be able to utilize the first spouse to die’s unused exclusion amount.

Seasoned trusts and estates practitioners know certain truths, such as:

  • Stuff happens.
  • Some estate tax disputes should not be litigated, but they are anyway.
  • Sometimes justice is done.

The recent case of Estate of Skeba (Civil Action No 17-cv-10231, D NJ Oct 3, 2019)) in the District Court of New Jersey reflects all of the above.

In Skeba, the decedent died on June 10, 2013.  The estate was valued at approximately $13.1 million and was largely illiquid, as $10.2 million of value was real estate.  On March 6, 2014, a few days before the due date of the estate tax return, the executor filed for a six month extension of time to file the return and pay the estate taxes.  The executor included a payment of $725,000, and explained that the estate was illiquid, they were working to complete a mortgage on a substantial commercial property in the estate, there had been delays in getting valuations and contested estate litigation, and that they expected the mortgage would be complete in 14 days.  Stuff happens.

About two weeks later on March 18, 2014, the refinance was completed and the estate made a second tax payment of $2.745 million.

On June 25, 2014, the IRS approved the estate’s application for an extension of time to file the estate tax return, granting a six month extension.

On July 8, 2014, the IRS approved the estate’s application for an extension of time to pay the estate tax, granting a six month extension (even though the estate tax had already been paid).

The estate didn’t file the estate tax return for another year.  There was an ongoing Will contest, so the executor did not know if he had authority to act for the estate.  There were postponements due to illnesses of the litigants and one of the lawyers.  The executor was told several times by IRS officials that there would be no penalty as long as the tax was paid.  Stuff happens.

On June 30, 2015, the estate filed the estate tax return, reporting an overpayment of $941,000.

The IRS agreed with the overpayment of tax, but also found that the estate was subject to a “failure to file” penalty of $451,000, equal to 25% of the unpaid tax because the return was filed late.  The IRS calculated the unpaid tax as the amount of tax due less the $725,000 that had been paid on the original due date of the return.

The estate filed for an abatement of the penalty due to reasonable cause.  This was rejected in November, 2015.  The IRS said the estate did not establish reasonable cause or show due diligence.  On these facts?  Really?

The estate filed an appeal with IRS Appeals.  Appeals never responded.

In the litigation that followed, the IRS ignored that it had granted extensions of time to file and pay, and that its representatives had told the executor there would be no penalty as long as the tax was paid. The IRS ignored that the estate had overpaid the tax due by $941,000 eight days after the original due date of the return.  Instead, the IRS instead argued that the return was filed late, the tax had not been paid in full on the original due date, and therefore, the failure to file penalty should apply.  Some disputes should not be litigated, but they are anyway.

Judge Sheridan of the District Court imposed some sense on the government, finding for the estate, and holding that the IRS’ denial of the request for abatement of penalties was arbitrary and capricious.  Sometimes justice prevails.

In a news release on July 26, 2019, the IRS announced that it was sending letters to taxpayers with virtual currency transactions that potentially failed to report income and pay the resulting tax.  See IR-2019-132.

The announcement is an indication of increased IRS collection and enforcement activity in the area of virtual currency.  The IRS recently received information about approximately 13,000 taxpayers with virtual currency transactions through a subpoena of the virtual currency exchange, Coinbase.  The IRS expects to send letters to more than 10,000 taxpayers by the end of August.

For taxpayers receiving a letter from the IRS, there are three variations:  Letter 6173, Letter 6174 or Letter 6174-A.  The IRS has previously released Notice 2014-21, which explains that the IRS treats virtual currency as property for federal tax purposes, and discusses the tax treatment of the sale or exchange of virtual currency and mining operations.

The news release also states that taxpayers who do not properly report the income tax consequences of virtual currency transactions may be liable for tax, penalties and interest.  In some cases, taxpayers could be subject to criminal prosecution.