This article was last updated on 12/15/2020.
Recently-released IRS Notice 2020-75 clarified its position on state and local income taxes imposed on and paid by a partnership or an S-corporation on its income. Prior to this notice, the deductibility of such taxes was uncertain. The notice states that these expenses will be allowed in full when computing a taxpayer’s income or loss from a partnership or S-corporation, providing much-needed clarity and potentially eliminating the negative effects of a rule put in place by the Tax Cut and Jobs Act.
In general, the income of an S-corporation or a partnership (pass-through entity) is not taxed at the entity level. Instead, the income passes through to the shareholders, members, or partners where it is subject to federal, state, and local income taxes.
Taxpayers who elect to itemize their individual federal income tax returns are allowed a deduction for the state and local income taxes (SALT deduction) they pay during the year. The SALT deduction includes taxes paid on real estate, personal property taxes, state income taxes, and general sales taxes.
In December 2017, Congress passed and President Trump signed the Tax Cut and Jobs Act (TCJA), the most expansive tax legislation since the Tax Reform Act of 1986. The effects of the TCJA were mainly to lower corporate and individual income taxes, however, it did include some revenue-raising items. One of the revenue raisers was a cap on the on the SALT deduction available to individual taxpayers.
The TCJA imposed a strict limit of $10,000 on the amount of state and local income taxes an individual taxpayer could deduct in a given tax year. This applies to tax years beginning after December 31, 2017 and before January 1, 2026. Prior to the TCJA, there was no such limitation on the SALT deduction. Individuals with large state income tax expenses and real estate tax expenses were previously allowed to deduct these items in full, but are now subject to a maximum deduction of $10,000. The excess SALT expenses are nondeductible for tax purposes.
While the limitation reduces the deductions available to individual taxpayers it does not apply to state and local taxes paid or accrued in connection with conducting a trade or business. Thus, the limitation on the SALT deduction does not apply to corporate taxpayers.
In response to the TCJA’s limitations on the SALT deduction, some states endeavored to mitigate the effect of the limitation on their residents. States attempted several methods to avoid the limitation, but the IRS mostly disallowed these methods. However, it now appears that the IRS will respect one of these methods.
Since the tax is now an entity-level tax, it is not subject to the $10,000 limitation.
Louisiana and several other states are circumventing the SALT deduction limitation by converting what is generally an individual state income tax liability (subject to the $10,000 limitation) to an entity-level state tax liability that is not subject to the limitation.
On June 22, 2019, Governor Jon Bel Edwards signed into law Act 442. The principal provisions of the bill are designed to allow certain pass-through entities the option to elect to file as a corporation for state tax purposes, to pay tax on its income at the entity level, and to exclude such income from the state tax base of its shareholder, partner, or member. Importantly, the tax rates established for entities making the election range from 2% to 6%, similar to individual income tax rates, and lower than Louisiana corporate tax rates.
Thus, the Act essentially allows a partnership or S-corporation to pay income taxes at the entity level. The individual shareholders or partners would no longer report the income on their state income tax returns, and thus no longer pay state taxes at the individual level. Since the tax is now an entity-level tax, it is not subject to the $10,000 limitation and can be deducted in full on the entity’s tax return.
At the time Act 442 was passed, it was uncertain the IRS would respect the entity-level deduction and allow it in full. The IRS had ruled other attempts to circumvent the SALT deduction limitation were invalid and most practitioners thought they would rule similarly regarding Act 442. However, IRS Notice 2020-75 states that they intend to issue proposed regulations to clarify that state and local income taxes imposed on and paid by a partnership or an S-corporation are allowed as a deduction in full by the pass-through entity.
The notice provides the clarity needed to deduct state and local income taxes at the entity level and avoid the $10,000 limitation put in place by the TCJA. We await the proposed regulations from the IRS for some additional details but this notice is a pleasant surprise. The new rules can be applied to specified income tax payments made in a tax year ending after December 31, 2017 and should be considered going forward.
This clarification from the IRS will be beneficial to taxpayers who are subject to the SALT cap of $10,000 and operate a business taxed as a partnership or S-corporation. However, the election is permanent and cannot be revoked without specific approval from the Department of Revenue. Taxpayers should consult their tax advisors regarding the pros and cons of the election. Contact us today to discuss how this method may work in your specific circumstance.