The Treasury Department and IRS recently released Notice 2020-75 indicating that proposed regulations will be issued on the deductibility of state and local tax payments made by passthrough entities. Importantly, the Notice indicates that amounts paid by a passthrough entity for the state and local taxes described in IRC § 164(b)(2) will be deductible for an individual owner of the passthrough entity, without regard to whether the state tax is mandatory or elective. For taxable years beginning after December 31, 2017 and before January 1, 2026, the Tax Cuts and Jobs Act (TCJA) limited an individual’s itemized deduction for state and local taxes paid to $10,000. In response, a handful of states adopted passthrough entity tax regimes that were intended to bypass the $10,000 SALT limitation by imposing a tax directly on the passthrough entity and, correspondingly, providing the owners of the pass-through entity with a tax credit or deduction to fully or partially mitigate the additional expense. Only one state, Connecticut, made its pass-through entity level tax mandatory. Six states adopted elective pass-through entity taxes. Below is a summary of the states that have these laws.
Mandatory Passthrough Entity Tax
- Connecticut: Each individual subject to Connecticut personal income taxes who is a member of a passthrough entity (defined for Connecticut purposes as an affected business entity) is entitled to a credit against his/her Connecticut individual income tax equal to the person's direct and indirect pro-rata share of the tax paid by the passthrough entity of which such person is a member multiplied by 87.5 percent. Any credit that exceeds such person’s tax liability will be refunded to such person. A nonresident partner is not required to file a Connecticut return if such partner does not owe Connecticut tax after this tax credit is applied.
Elective Passthrough Entity Taxes
- Louisiana: S corporations and other passthrough entities may elect to pay tax at the entity level as if the entity was a C corporation. Owners that are individuals are permitted to exclude the income from their own returns. Electing to pay tax at the entity level will not subject a passthrough entity to the state’s franchise tax.
- Maryland: Passthrough entities are permitted to pay tax at the entity level for resident individual and entity partners. The county tax rate plus the highest marginal rate for individuals is applied to the distributive/pro-rata share of a resident individual member while the corporate rate is applied to the distributive/pro-rata share of a resident entity member. Each member is then allowed to claim a credit against their tax for the member’s proportionate share of the tax paid by the passthrough entity. The tax does not apply to a partner that is itself a passthrough entity, a REIT, or an entity exempt under IRC § 501. The tax cannot exceed the sum of all the members’ shares of the passthrough entity’s distributive cash flow.
- New Jersey: Non-corporate members of a passthrough entity are provided with a refundable gross income tax credit, which is equal to the member’s pro rata share of tax paid. The credit for corporate members operates similarly, with the exception that the credit is not refundable, but may be carried forward for up to 20 years. The tax is imposed on the sum of each member’s distributive share, which is then multiplied against the applicable rate. Please note that making this election does not appear to eliminate the passthrough entity’s nonresident withholding obligations and that additional guidance is forthcoming on various procedural considerations.
- Oklahoma: A partnership or S corporation is permitted to make an election to be considered an “electing pass-through entity” for Oklahoma income tax purposes. An electing pass-through entity is then responsible for determining the taxable income of each owner and paying the total tax due for all owners. For tax years beginning on or after January 1, 2020, an election may be made at any time during the preceding tax year or two months and 15 days after the beginning of the tax year. Once an election is made, it is binding until revoked.
- Rhode Island: Owners are entitled to a credit in the amount of the tax paid by the passthrough entity, on a pro rata basis. The election must be made on an annual basis and is effectuated by filing the prescribed tax form and remitting the appropriate tax.
- Wisconsin: Entities treated as partnerships for federal income tax purposes and S Corporations may elect to pay tax at the entity level. Individual owners are then allowed a subtraction from Wisconsin adjusted gross income for the owner’s share of income or gain from the partnership or S Corporation.
Please contact Brad Wilhelmson at 312- 665-2076 with questions on the Notice or the state pass-through entity tax regimes.