Treasury and IRS Will Respect State Pass-Through Entity Workaround Laws Aimed at Circumventing TCJA’s SALT Deduction Cap

Partnerships and S corporations based in a state and local jurisdiction that imposes a mandatory or elective income tax at the entity level are allowed to fully deduct state and local income taxes from the entity’s taxable income, Treasury and IRS stated in Notice 2020-75. The notice said that Treasury and IRS plan to issue proposed regulations to clarify partnerships and S corporations that pay state income tax imposed and paid at the entity level can fully deduct those taxes at the entity level. The result is that, with respect to these payments, the individual owners are not subject to the SALT deduction cap on their individual federal income tax returns.

Background

The Tax Cuts and Jobs Act (TCJA) capped at $10,000 the amount of state and local tax (SALT) payments that individual filers could deduct from their federal tax returns. The SALT deduction cap applies to taxable years beginning after December 31, 2017 and before January 1, 2026. States such as Connecticut, Louisiana, New Jersey, Oklahoma, Rhode Island and Wisconsin sought to allow residents to mitigate the negative consequences of the federal SALT deduction limit by enacting so-called pass-through entity workarounds. Under these state laws, state income tax is imposed directly on the pass-through entity and there was a corresponding or offsetting owner-level state tax benefit through a credit, deduction or exclusion. Some of the pass-through entity workaround regimes are mandatory, while others are elective.

New Guidance

The notice said that Treasury and IRS were aware that there is uncertainty as to whether entity-level tax payments made under state pass-through entity workaround laws must be taken into account in applying the $10,000 SALT deduction limitation at the individual owner level. Forthcoming proposed regulations will clarify that specified income tax payments are deductible by partnerships and S corporations in computing their non-separately stated income or loss. Specified income tax payment is defined as any amount paid by a partnership or S corporation to a state, a political subdivision of a state, or the District of Columbia (domestic jurisdiction) to satisfy its liability for income taxes imposed by the domestic jurisdiction on the partnership or S corporation. The notice states that both elective and mandatory entity-level income tax laws will be respected for purposes of allowing the full deduction. Prior to the issuance of the notice, it was unclear whether regimes that were entirely elective or had elements of optionality would be respected and whether regimes that reduced the partners’ or shareholders’ own individual income tax liability under the domestic jurisdiction law would be respected.

The notice provides that specified income tax payments are non-separately stated items under Sec. 702 for partnerships or under Sec. 1366 for S corporations. This means that these payments are treated as partnership or S corporation deductions, similar to property taxes, in determining the partnership or S corporation non-separately stated income or loss (that is, its ordinary income or loss). This results in the payments not being listed separately to specific owners and therefore, not subject to the SALT cap at the individual owner level. There may be implications beyond the applicability of the SALT workaround that pass-through entities and their owners need to consider prior to electing into any elective regimes (which includes looking at the resident and nonresident composition of its owners), and in analyzing the impact of any mandatory regimes.

Domestic Jurisdiction Laws

The notice will only apply in instances where a domestic jurisdiction specifically enacts a law that imposes the income tax on the pass-through entity. It does not apply to payments made by entities pursuant to a composite tax return, which does not impose the tax on the entity, but collects the tax through the entity. Domestic jurisdictions that have already enacted SALT workarounds have handled the issues in different ways and there may be interactions with other aspects of the domestic jurisdiction tax law that need to be carefully considered. We anticipate that more states will move toward proposing and enacting these types of pass-through tax provisions given the new stance from Treasury and IRS. However, crafting these provisions is no simple matter and would likely involve a great deal of consideration, particularly in large states that have not yet considered this type of legislation.

Applicability

The proposed regulations described in the notice will apply to specified income tax payments made on or after November 9, 2020. The proposed regulations will also permit taxpayers to fully deduct specified income tax payments made in a taxable year of the partnership or S corporation ending after December 31, 2017, and made before November 9, 2020, provided that the specified income tax payment is made to satisfy the liability for income tax imposed on the partnership or S corporation under a law enacted before November 9, 2020. Prior to the issuance of the proposed regulations, taxpayers may rely on the provisions of the notice with respect to specified income tax payments.

The Takeaway

The notice comes as welcome news to individual owners of partnerships and S corporations who remained uncertain as to whether they could fully deduct state and local income taxes even after the states they operated in enacted laws to help them mitigate the negative impact of the $10,000 federal SALT deduction limit. The government’s announcement is likely to spur more state and local jurisdictions to enact pass-through entity workaround laws. Partnership and S corporation owners in states with elective workaround regimes will need to evaluate whether to make the election and the impact this would have on the partners or shareholders. Consult with an Andersen advisor for an analysis of how this development impacts your business.