IRS Announces Proposed Regulations Permitting SALT Deduction “Workarounds”
In the wake of the Tax Cuts and Jobs Act’s (TCJA) substantial limitation on the deductibility of state and local taxes paid at the individual level, several states passed legislation imposing an entity-level income tax on pass-through entities. Prior to the TCJA, individuals could deduct the full amount of income taxes paid on income received from pass-through entities, such as partnerships and S corporations, as an itemized deduction on Schedule A of their Form 1040. However, the TCJA limited the individual state tax deduction to a total amount of $10,000 while still allowing C corporations a full deduction for state taxes paid.
Connecticut first enacted a mandatory pass-through entity tax to “work around” the $10,000 limitation. Connecticut’s law also provides a corresponding, or offsetting, owner-level tax benefit, such as a full or partial credit, deduction, or exclusion for taxes paid at the entity level. Other states, such as Louisiana, Rhode Island, Oklahoma, Maryland, New Jersey, and Wisconsin, enacted elective versions of the Connecticut legislation.
After examining Connecticut and other states’ legislation, the IRS issued Notice 2020-75 announcing its intent to issue proposed regulations to clarify the deductibility of state and local income taxes imposed on and paid by a partnership or an S corp on its income. The notice clarifies that the IRS will allow a deduction by the partnership or S corp in computing its nonseparately stated taxable income or loss for the taxable year for a “specified income tax payment.”
A “specified income tax payment” includes any amount paid by a partnership or S corp to a state or local jurisdiction pursuant to a direct imposition of income tax by the jurisdiction on the partnership or S corp, 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 based on their share of the amount paid by the partnership or S corp.
The IRS’ announcement of forthcoming proposed regulations is positive news for taxpayers and provides more certainty that the IRS will not require these entity-level specified income tax payments to be taken into account in applying the $10,000 limitation at the owner level. As a result, more states are expected to pass laws allowing pass-through entities to pay a historically individual tax at the entity level to allow individuals to avoid the federal limit on personal tax deductions for state and local taxes at the individual level. Despite this welcome development, taxpayers should still carefully review their situations before electing into a state’s entity-level tax regime as it’s still uncertain whether all states that provide their residents a credit for taxes paid to nonresident states will still allow a credit to the extent the tax liability is shifted to the pass-through entity. If not allowed, an owner could potentially be trading a dollar-for-dollar state tax credit for an increased federal deduction.
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