IRS Ok’s Passthrough entity Workarounds for SALT Cap
Passthrough Taxes Created by States as SALT Workarounds Will Be Allowed as Deduction Without Regard to any SALT Limitation
The IRS has now released guidance that proposed regulations will be released that will allow partnerships and S corporations to deduct state and local income taxes imposed on the entity. This development resolves an issue that has been around since Connecticut enacted the first passthrough tax following the passage of the Tax Cuts and Jobs Act.
On Monday, the IRS announced that it will be issuing proposed regulations allowing partnerships and S corporations to deduct state and local income taxes in full. Under the Tax Cuts and Jobs Act, individual taxpayers are currently limited to a state tax deduction of $10,000, annually (otherwise known as the “SALT cap”). Some states, including New Jersey, Connecticut and several others have enacted a so-called “workaround” of the SALT Cap, either mandating or allowing business entities to elect that state tax be paid by the business rather than the business owners in order to maintain the full federal tax benefit of state taxes.
In the announcement, the IRS indicated that the forthcoming regulations will treat these types of state tax payments as deductible and thereby reducing the federal income passed through to the owners. The IRS also clarified that they will respect the deduction whether the business level state tax is mandated or elected into. This announcement is a welcomed clarification from the IRS, will alleviate much of the uncertainty surrounding these SALT Cap workarounds enacted by certain states and may result in other states introducing similar tax regimes.
The IRS notes the following:
Certain jurisdictions described in section 164(b)(2) have enacted, or are contemplating the enactment of, tax laws that impose either a mandatory or elective entity-level income tax on partnerships and S corporations that do business in the jurisdiction or have income derived from or connected with sources within the jurisdiction. In certain instances, the jurisdiction’s tax law provides a corresponding or offsetting, owner-level tax benefit, such as a full or partial credit, deduction, or exclusion. The Treasury Department and the IRS are aware that there is uncertainty as to whether entity-level payments made under these laws to jurisdictions described in section 164(b)(2) other than U.S. territories must be taken into account in applying the SALT deduction limitation at the owner level.
The IRS begins by announcing that they will be issuing proposed regulations to allow this deduction:
.01 Purpose and scope. The Treasury Department and the IRS intend to issue proposed regulations to provide certainty to individual owners of partnerships and S corporations in calculating their SALT deduction limitations. Based on the statutory and administrative authorities described in section 2 of this notice, the forthcoming proposed regulations will clarify that Specified Income Tax Payments (as defined in section 3.02(1) of this notice) are deductible by partnerships and S corporations in computing their non-separately stated income or loss.
The Notice provides the following with regard to the deduction of such payments:
(2) Deductibility of Specified Income Tax Payments. 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.
The term Specified Income Tax Payment is defined as follows:
For purposes of section 3.02 of this notice, 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 (Domestic Jurisdiction) to satisfy its liability for income taxes imposed by the Domestic Jurisdiction on the partnership or the S corporation. This definition does not include income taxes imposed by U.S. territories or their political subdivisions.
One area of concern that some had with regard to the entity level passthrough taxes imposed by states was that some were imposed at the election of the entity. Would the fact that an entity has elected to pay the tax eliminate the treatment as a tax imposed on the entity? The IRS has decided that is not an issue. Similarly, the fact that a partner ends up with a benefit against his/her tax liability also is not a problem for such taxes.
For this purpose, a Specified Income Tax Payment includes any amount paid by a partnership or an S corporation to a Domestic Jurisdiction pursuant to a direct imposition of income tax by the Domestic Jurisdiction 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 that is based on their share of the amount paid by the partnership or S corporation to satisfy its income tax liability under the Domestic Jurisdiction’s tax law and which reduces the partners’ or shareholders’ own individual income tax liabilities under the Domestic Jurisdiction’s tax law.
The tax will not be a separately stated item, but rather will be part of the non-separately stated income or loss from the partnership or S corporation:
Any Specified Income Tax Payment made by a partnership or an S corporation during a taxable year does not constitute an item of deduction that a partner or an S corporation shareholder takes into account separately under section 702 or section 1366 in determining the partner’s or S corporation shareholder’s own Federal income tax liability for the taxable year. Instead, Specified Income Tax Payments will be reflected in a partner’s or an S corporation shareholder’s distributive or pro-rata share of nonseparately stated income or loss reported on a Schedule K-1 (or similar form).
As well, the amounts paid will not be taken into account for the individual SALT limitation:
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 who is a partner in the partnership or a shareholder of the S corporation.
The applicability date allows taxpayers to deduct taxes paid on such taxes generally for years ending after December 31, 2017:
The proposed regulations described in this notice will apply to Specified Income Tax Payments made on or after November 9, 2020. The proposed regulations will also permit taxpayers described in section 3.02 of this notice to apply the rules described in this 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 this notice with respect to Specified Income Tax Payments as described in this section 4.
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