In January 2020, New Jersey passed a law that allows pass-through entities to pay income tax at the entity level.
On November 10, 2020, the IRS today issued Notice 2020-75, which announces rules to be included in forthcoming proposed regulations. Specifically, the proposed regulations will clarify that state and local income taxes imposed on and paid by a partnership or 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, and therefore are not subject to the state and local tax deduction limitation for partners and shareholders who itemize deductions.
The notice describing the forthcoming proposed regulations applies to these types of income taxes starting today, and also allows taxpayers to apply these rules to specified income tax payments made in a taxable year of a partnership or an S corporation ending after Dec. 31, 2017, and before the date, the forthcoming proposed regulations are published in the Federal Register.
Updates on the implementation of the Tax Cuts and Jobs Act (TCJA) can be found on the Tax Reform page of IRS.gov.
What’s the law? What does this mean?
Most pass-through entities are owned by an individual or group of individuals. Income that the business earns flows through to the owners and the owners pay tax on it.
New Jersey’s law, the Pass-Through Business Alternative Income Tax Act, is changing things up. This law allows the business to pay income tax to the state of New Jersey, not the owners.
In 2017, the Tax Cuts and Jobs Act limited individual taxpayers to a $10,000 deduction for state and local taxes on their federal income tax return.
So, when taxpayers add up the personal property taxes or real estate taxes they pay to states, they can only claim a $10,000 deduction if they itemize deductions. Even if they paid more than $10,000 in state and local taxes.
Does this limitation impact many taxpayers? Maybe not.
According to the Tax Policy Center, “Less than one-third of tax filers opted to itemize deductions on their federal income tax returns in 2016, but virtually all who itemized claimed a deduction for state and local taxes paid.”
For tax filers with incomes exceeding $100,000, their average claim was about $21,000. Members of that group probably aren’t happy with this limitation. Plus, more taxpayers may have elected to itemize their deductions if this limitation wasn’t created in 2017.
New Jersey is giving taxpayers a way to work around this limitation by allowing pass-through entities to pay income tax instead of the individual. It could help taxpayers who have ownership interest in pass-through entities maximize their state and local tax deduction on their personal federal returns.
Who does this benefit?
Fortunately, this law isn’t mandatory. It’s up to owners to make the election. Owners include the shareholders of S corporations, partners in a partnership, and members of an LLC.
If they benefit from the entity paying New Jersey income tax and it helps them avoid the $10,000 deduction limit, they may want the entity to pay the income tax.
If the owners frequently exceed the $10,000 deduction limit, they may want to shift the tax responsibility to the entity so they benefit from a greater deduction and more tax savings on their personal federal income tax return.
In addition, owners can claim a refundable credit for their share of the tax paid on their personal return. If they receive an excess credit, they can carry it forward for 20 years.
How does New Jersey define pass-through entities?
A pass-through entity is a partnership, an S corporation, or a limited liability company (LLC) with at least one member who is liable for tax on distributive proceeds pursuant to the New Jersey Gross Income Tax Act.
Single-member LLCs, sole proprietorships, and entities with no income aren’t eligible for this election.
What happens if an entity makes this election?
First, all owners must agree to make the election. Then, the owners or a member who has the authority to make the election for all members must make the election annually by March 15, the entity’s return due date.
How much will the business pay in taxes?
The company’s tax is based on the sum of each partner’s distributive proceeds which include:
- net income
- guaranteed payments
All distributive proceeds must be derived from or connected with sources within New Jersey.
When does this law go into effect?
This law is effective for tax years beginning on or after January 1, 2020. Since 2020 is the first year this option is available, taxpayers won’t be penalized for failing to file or make estimated tax payments this year.
Please contact Werdann DeVito LLC with any questions and the application of this law.