The Tax Cuts and Jobs Act of 2017 (TCJA) limits an individual’s deduction for state and local taxes (SALT) paid to $10,000 ($5,000 in the case of a married individual filing a separate return). In response, some states passed statutes allowing businesses that pass through income to their owners (pass-through entities like S corporations or partnerships) to elect to pay income taxes at the entity level, potentially resulting in a full deduction for the entity (and indirectly, a full deduction for the owners).
Without this election, the income tax burden would be borne by the owners, and their deduction for the income taxes paid could be limited by the new $10,000 TCJA SALT cap. Taxpayers and advisors were uncertain as to whether the government would allow a pass-through entity to deduct income taxes at the entity level, because it appeared to circumvent the $10,000 SALT cap.
In a recently released notice (Notice 2020-75), the government holds it will allow pass-through entities to fully deduct entity level income tax payments, provided certain requirements are met.
What is Included in Notice 2020-75
The notice states that the government intends “to issue proposed regulations to clarify that state and local income taxes imposed on and paid by a partnership or an 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.”
Only a “Specified Income Tax Payment” is deductible, defined as “any amount paid by a partnership or an S corporation to a state, a political subdivision of a state, or the District of Columbia (Domestic Jurisdiction) to satisfy its liability for income taxes imposed by the Domestic Jurisdiction on the partnership or the S corporation.”
Accordingly, a state must pass a specific statute providing for pass-through entity level taxation in order for this notice to apply. Merely allowing a pass-through entity to make withholding tax payments on behalf of owners will not qualify because those withholding tax payments are treated as payments made by the owners and not as payments in satisfaction of the pass-through entity’s tax liability.
At last count, a majority of states with an income tax have not passed statutes allowing for a pass-through business to pay income taxes at the entity level, but this notice may encourage more states to enact similar statutes.
The Takeaway for the $10,000 SALT Limitation
The notice provides the proposed regulations will apply to Specified Income Tax Payments made on or after November 9, 2020. The rules outlined in the notice will also apply to Specified Income Tax Payments made by partnerships and S corporations in taxable years ending after December 31, 2017, provided that the Specified Income Tax Payment “is made to satisfy the liability for income tax imposed on the partnership or S corporation pursuant to a law enacted prior to November 9, 2020.”
This notice and the forthcoming proposed regulations will allow eligible owners of pass-through entities to effectively deduct the full amount of any associated business income taxes. The entity level deduction, by reducing allocable taxable income, will also reduce the amount of allocable qualified business income and any possible Section 199A deduction. Owners of pass-through businesses should consult their tax adviser to determine whether states where the pass-through entity does business have enacted a statute that complies with the requirements of Notice 2020-75.