The 2017 Tax Act made life harder on individuals living in high tax states (such as New York, New Jersey, and California) by limiting the deduction for state and local taxes (“SALT”) to $10,000. In an attempt to circumvent this restriction, several states have adopted a new pass-through entity tax imposed on partnerships, LLCs, and S Corps, which is deductible in computing the entity’s taxable income passed through to its partners or shareholders. The state then allows those partners or shareholders to get a credit for all or a portion of their share of this new tax against their own personal state tax liability.
With the holiday season approaching, the IRS gave affected taxpayers a gift by announcing they will issue proposed regulations allowing the pass-through entity to fully deduct this new tax even though it may be viewed as a surrogate for an impermissible SALT deduction of its owners. Notice 2020-75. This approach, however, offers no assistance to wage earners or self-employed individuals who pay state tax and remain subject to the SALT deduction limitation. It also offers no assistance to business being conducted through a single member LLC.
New Jersey, Connecticut and five other states have adopted this entity tax. In Connecticut, this tax is mandatory whereas in New Jersey and five other states (Louisiana, Maryland, Oklahoma, Rhode Island, and Wisconsin), the tax is elective, so an entity has the choice to apply it or not. Elective treatment is beneficial since this new tax may not work to the benefit of all partners. Without a pass-through entity tax, depending on income sourcing and nexus of the entity, non-resident partners may be able to pay less state tax on the flow through income if they live in a low or no income tax jurisdictions. On the other hand, with the pass through entity tax election, those same non-resident partners may be unwittingly subsidizing their resident partners personal state income tax. Each entity should model out the impact on all its partners to determine if it should elect to be subject to this new tax.
New Jersey’s pass-through entity tax is imposed at graduated rates that range from 5.675% to 10.9%, which is slightly higher than the maximum individual income tax rate of 10.75%. Single member LLCs and sole proprietorships cannot, however, elect to pay the pass-through entity tax.
To illustrate, a New Jersey partnership has five individual partners (each having a 20% interest) and $5M of NJ taxable income. Without this new tax, each partner has $1M of taxable income and NJ tax paid by the partner is non-deductible due to the SALT limitation.
If the partnership elects, the partnership pays $427,887.50 of this new tax, which is deductible, so the partnership only reports $4,572,112.50 of taxable income ($5M minus $427,887.50). Each partner includes 20% of $4,572,112.50 taxable income on its tax return, which is $914,422.50, rather than $1M. Taking into account the maximum 37% federal tax rate, this strategy can reduce the individual’s federal taxes by $31,664. While each partner is subject to NJ tax on this income, NJ gives the partner a tax credit for 20% of the LLC’s state tax payment of $427,887.50 or $85,577.50, which can eliminate or significantly reduce added NJ tax.
Planning Tip: Individuals using single member LLCs to conduct business could admit a second member, which makes the LLC into a tax partnership that can take advantage of this new tax. The second member can have a small interest in the LLC (1%) so the individual still retains control and most of the cash flow from the business. Alternatively, the individual can incorporate his or her business and elect to treat it as an S Corporation, which can also take advantage of this new tax.
Other states may look to follow the lead of these pioneering states and adopt their own pass-through entity tax. The good news is there is now an avenue for some taxpayers to reclaim the SALT deduction through this new entity level tax. Like many other tax changes, its use will not be simple, and it may not work to the benefit of all partners. Any entity that has a choice to elect or not elect needs to now “crunch the numbers” to see if the new law makes sense for it and its owners.