Kulzer & DiPadova, P.A.
76 E. Euclid Avenue, Suite 300
Haddonfield, New Jersey 08033-2342

P: 856.795.7744
F: 856.795.8982
E: info@kulzerdipadova.com

News, Articles & Resources

IRS Allows Pass-Through Entity Workarounds to SALT Deduction Limitation

Posted In:
IRS Allows Pass-Through Entity Workarounds to SALT Deduction Limitation

In Notice 2020-75, the IRS announced that the Department of the Treasury and the IRS intend to issue proposed regulations to clarify that state and local income taxes imposed on and paid by a partnership or an S corporation on its income are allowed as a deduction by the partnership or S corporation in computing its non-separately stated taxable income or loss for the taxable year of payment.

Section 164(a) of the Internal Revenue Code (the “Code”) generally allows a deduction for certain taxes which are paid or accrued during the taxable year, including (i) state and local, and foreign, real property taxes, (ii) state and local personal property taxes, and (iii) state and local, and foreign, income, war profits, and excess profits taxes. In addition, Section 164 allows a deduction for state and local, and foreign, taxes not described in the preceding sentence that are paid or accrued within the taxable year in carrying on a trade or business or an activity described in Section 212 of the Code.

However, Section 164(b)(6), as added by the Tax Cuts and Jobs Act, limits an individual’s deduction under Section 164(a) (the “SALT deduction limitation”) to $10,000 ($5,000 in the case of a married individual filing a separate return) for the aggregate amount of the following state and local taxes paid during the calendar year: (i) real property taxes, (ii) personal property taxes, (iii) income, war profits, and excess profits taxes, and (iv) general sales taxes. The SALT deduction limitation applies to taxable years beginning after December 31, 2017 and before January 1, 2026. Importantly, the SALT deduction limitation does not apply to state and local taxes paid by business entities.

After the enactment of the SALT deduction limitation, certain states, including New Jersey, attempted to create “workarounds” to the limitation by taking advantage of the charitable deduction. However, on June 11, 2019, the Treasury issued final Treasury Regulations which  effectively prevent the types of charitable workarounds contemplated by the states.

As another type or workaround, certain states, again including New Jersey, have enacted, or are contemplating enacting, tax laws that impose either a mandatory or elective entity-level income tax on partnerships and S corporations that do business in or have income derived from sources in the state. These types of pass-through entity workarounds are intended to take advantage of the fact that the SALT deduction limitation does not apply to state and local taxes paid by businesses.

Generally, partnerships and S corporations are not taxable as entities, but they are required to separately determine their taxable income or loss as an entity. The partnership or S corporation must report its income or loss to the IRS and to the partners or shareholders, who must take into account their respective shares of the partnership’s or S corporation’s items of income, deductions, gains, losses, and credits on their own tax returns.

Certain items of the partnership’s or S corporation’s income, deductions, gains, losses and credits (such as long- and short-term capital gains and losses, and charitable contributions) must be separately stated. The character of these items at the entity level is preserved and passed through to the individual partners or shareholders. The individual partner or shareholder must then combine his or her share of each separately stated item with similar items realized by him or her from other sources for purposes of applying various special rules and limitations with respect to those items. Items that are not separately stated are included by the partners or shareholders as a component of their taxable income or loss from the partnership or S corporation.

Without the pass-through entity workarounds, an entity’s state and local income tax liabilities are passed through to the owners, who must pay the tax, and then the owners are subject to the SALT deduction limitation in computing their federal income tax liabilities. However, under the pass-through entity workarounds, the pass-through entity elects to pay the state and local income tax at the entity level. For state purposes, the owners must still include in their income their share of the entity’s income, but, in certain instances, the state’s tax law provides a corresponding or offsetting, owner-level tax benefit, such as a full or partial credit, deduction, or exclusion for the owner’s share of the tax paid by the entity. In New Jersey, for example, the owners are allowed a refundable gross income tax credit in an amount equal to the owner’s pro rata share of the tax paid by the entity.

There was uncertainty, however, for federal purposes, as to whether the entity-level payments to the states must be separately stated when the deduction is passed through to the partners or shareholders, and thus taken into account in applying the SALT deduction limitation at the owner level. In order to provide certainty, Notice 2020-75 states that the Treasury Department and the IRS intend to issue proposed regulations that will clarify that “Specified Income Tax Payments” are deductible by partnerships and S corporations in computing their non-separately stated income or loss.

The term “Specified Income Tax Payment” means any amount paid by a partnership or an S corporation to a state, a political subdivision of a state, or the District of Columbia (together hereinafter referred to as a “State”) to satisfy its liability for income taxes imposed by the State on the partnership or the S corporation. This definition does not include income taxes imposed by U.S. territories or their political subdivisions.

A Specified Income Tax Payment includes any amount paid by a partnership or an S corporation to a State pursuant to a direct imposition of income tax by the State on the partnership or S corporation, without regard to whether the imposition of and liability for the income tax is the result of an election by the entity, or whether the partners or shareholders receive a partial or full deduction, exclusion, credit, or other tax benefit for the tax paid by the entity in satisfying their own state income tax liability, thus reducing their own individual state income tax liabilities.

If a partnership or an S corporation makes a Specified Income Tax Payment during a taxable year, the partnership or S corporation is allowed a deduction for the Specified Income Tax Payment in computing its taxable income for the taxable year in which the payment is made. Such deduction need not be separately stated for purposes of determining the partner’s or shareholder’s own Federal income tax liability for the taxable year. Instead, Specified Income Tax Payments will be reflected in a partner’s or shareholder’s distributive or pro-rata share of non-separately stated income or loss reported on a Schedule K-1 (or similar form).  As a result, any Specified Income Tax Payment made by a partnership or an S corporation is not taken into account in applying the SALT deduction limitation to any individual partner or shareholder.

The proposed regulations will apply to Specified Income Tax Payments made on or after November 9, 2020. The proposed regulations will also permit taxpayers to apply the rules described in the Notice to 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 pursuant to a law enacted prior to 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.

Sign Up For Our Newsletter