IRS Approves Deduction for Entity-Level Income Tax Payment Made by Pass-Through Entities
In response to the $10,000 SALT deduction limitation under the Tax Cuts and Jobs Act, several states enacted pass-through entity-level income taxes as a workaround. Due to a recent Internal Revenue Service notice approving the workaround, expect more states to follow suit and find out what that may mean for you.
By: Betsy Tuck, SALT Manager
Since passage of the Tax Cuts and Jobs Act (“TCJA”) in December 2017, we have seen several states enact entity-level income taxes on pass-through entities (PTE) doing business within the states as a response to the $10,000 SALT deduction limitation on individuals under Internal Revenue Code (IRC) section 164(a).
The way these taxes generally work is that an entity-level income tax is legally imposed on and paid by a PTE. It is not a composite tax or withholding tax that is paid by the PTE on behalf of its individual owners and that is treated as a tax paid by the individual owners. The PTE owners receive a tax credit on their K-1s for their share of the tax paid by the PTE. That credit reduces or may eliminate the state personal income tax owed by the individual owner.
The idea behind the enactment of these taxes is that if the PTE is liable for and pays the tax, it can receive a federal deduction for state taxes paid. That deduction reduces the federal ordinary income that passes though to the K-1 owners, thereby reducing their federal income tax liability. The state tax credit received by the K-1 owners ensures that there is not a double income tax at the state level (i.e., at both the entity and individual level). The end result is the federal deduction for state taxes paid is shifted from the individual K-1 owner (who likely can’t deduct the full amount due to the $10,000 cap) to the PTE, which is not subject to any federal limitation for this deduction.
Following the enactment of these PTE taxes, there was some uncertainty as to whether the Internal Revenue Service (IRS) would allow the PTE to take the state tax paid deduction.
On November 9, 2020, the IRS issued Notice 2020-75, which clarified that a tax paid by a partnership or S corporation to a domestic jurisdiction to satisfy its tax liability pursuant to a “direct imposition of income tax by the Domestic Jurisdiction on the partnership or S Corporation” is deductible by the entity. The deduction is allowed regardless of whether the state PTE tax is elective or mandatory and regardless of whether the individual K-1 owners received a full or partial state tax credit or other state tax benefit. The notice also clarifies the deduction will be reflected as an item of non-separately stated income or loss reported to the partner or shareholder on Schedule K-1.
Currently, there are seven states that have enacted these PTE taxes as noted below, including whether the tax is mandatory or elective and the effective tax year.
- Connecticut – Mandatory – 2018
- Louisiana – Elective – 2019
- Maryland – Elective – 2020
- New Jersey – Elective – 2020
- Oklahoma – Elective – 2019
- Rhode Island – Elective – 2019
- Wisconsin – Elective – 2018 for S-corporation; 2019 for Partnerships
Please reach out to your Aprio tax advisor for more information about how this guidance may apply to you.
This article was featured in the November/December 2020 SALT Newsletter.