New IRS Notice Facilitates SALT Cap Workaround
When signed into law on December 22, 2017, the Tax Cuts and Jobs Act (TCJA) was the most significant change to the U.S. tax code in more than 30 years. The goal was to simplify the tax code while making the United States corporate tax rate more competitive globally. Many of the tax law changes were welcomed by businesses, including the new 21% business tax rate, the Qualified Business Income Deduction for pass-through entity owners, temporary 100% bonus depreciation, and the expanded Section 179D deduction limits. However, one of the changes not welcomed was the cap on state and local taxes (SALT) of $10,000 for individual taxpayers. Many of these individuals who were now limited in the state and local income tax deduction amount that they could claim were pass-through entity owners (S-corporations, partnerships, and LLCs).
That law change led many states, including New Jersey, to implement SALT Cap workarounds to aid its taxpayers as far as recovering federal income taxes due to lost state tax deductions. Some did lose deductions due to the state tax cap. However, a significant number of taxpayers still came out ahead in the overall analysis of tax changes because the tax brackets and rates were reset favorably, and many of them previously had lost the benefit of the deduction anyway by being subject to the Alternative Minimum Tax (AMT). Nevertheless, on November 9, 2020, the IRS issued Notice 2020-75, allowing certain taxpayers to take advantage of various state tax law workarounds. We have provided a summary of the key details below as they affect and N.J. resident and nonresident income taxpayers.
New Jersey SALT Cap Workaround
New Jersey created a SALT Cap workaround when Governor Phil Murphy signed the Pass-Through Business Alternative Income Tax Act (P.L.2019, c320) into law earlier this year. The law states that starting in 2020, pass-through entities can elect to pay the tax due to the owners’ shares of distributive proceeds. Distributive proceeds mean any dividends, royalties, interest, rent, guaranteed payments, and gains of a pass-through entity connected to New Jersey sources. Pass-through owners would then be able to gain the full state tax benefit individually through the pass-through entity. The New Jersey law also has a provision whereby owners can claim a refundable tax credit for the amount of tax paid by the pass-through entity on their share of distributive proceeds. However, the federal government typically denies a deduction in situations where a perceived double tax benefit is realized.
Accordingly, taxpayers may need to evaluate whether the federal deduction or the New Jersey credit is better if they even can because the election to pay the state taxes will have already been made by the pass-through at the entity level. Pass-through entities include S-corporations that made N.J. S-corporation election, partnerships, and Limited Liability Companies (LLCs). Single-member LLCs and Sole Proprietorships are not permitted to participate.
Each year, the election for the New Jersey entities wanting to take advantage of this must be made by all pass-through entity owners or by an officer designated within the organization’s documents empowered to make such elections. The annual election must be made on or before the original due date of the entity’s New Jersey state tax return.
Why is the IRS Notice Important?
The recently issued Notice affirms that the IRS will cease to challenge state-based SALT Cap workaround programs, which it has done in the past. Instead, it clarifies that pass-through entities can deduct the entire amount of SALT liabilities at the entity level, thereby lessening the SALT cap’s impact implemented by the TCJA.
Effective Date
The changes outlined in the Federal Notice are effective for payments made on or after November 9, 2020. If a state SALT Cap workaround was enacted before this date, then the entity level deduction will be allowed to align with the state’s enactment date.
Contact Us
The recent IRS Notice provides welcome relief to Princeton and Trenton businesses unsure if the IRS would challenge the New Jersey workaround. The changes ensure the tax-saving opportunity for qualifying pass-through entities. If you have questions about the information outlined above or need assistance with another tax or accounting issue, Klatzkin can help. For additional information, click here to contact us. We look forward to speaking with you soon.
©2020 Klatzkin & Company LLP. The above represents our best understanding and interpretation of the material covered as of this post’s date and should not be construed as accounting, tax, or financial advice. Please consult your tax advisor concerning your specific situation.