KPMG report: IRS to respect deduction for elective passthrough entity taxes of various states
Deduction for elective passthrough entity taxes
IRS Notice 2020-75 (released November 9, 2020) indicates that proposed regulations will be issued on the deductibility of state and local tax payments made by passthrough entities.
Notice 2020-75 [PDF 108 KB] provides that amounts paid by a passthrough entity for the state and local taxes—as described in IRC section 164(b)(2)—will be deductible by an individual owner of the passthrough entity, without regard to whether the state tax is mandatory or elective.
For tax years beginning after December 31, 2017, and before January 1, 2026, the 2017 U.S. tax law (Pub. L. No. 115-97) or the law that is often referred to as the “Tax Cuts and Jobs Act” (TCJA) limits an individual’s itemized deduction for state and local taxes paid to $10,000—referred to as the “SALT limitation.”
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 these passthrough entities with a tax credit or deduction that would fully or partially mitigate the additional expense.
- Only one state, Connecticut, made its passthrough entity level tax mandatory.
- Six other states adopted elective passthrough entity taxes.
Below is a summary of the states that have these laws.
Mandatory passthrough entity tax
- Connecticut: Each individual taxpayer subject to Connecticut individual (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 that person's direct and indirect pro-rata share of the tax paid by the passthrough entity of which the individual is a member multiplied by 87.5%. Any credit that exceeds such person’s tax liability will be refunded to that individual. 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 the 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 section 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. Note that making this election does not appear to eliminate the passthrough entity’s nonresident withholding obligations and that additional guidance is expected to be forthcoming on various procedural considerations.
- Oklahoma: A partnership or S corporation is permitted to make an election to be considered an “electing passthrough entity” for Oklahoma income tax purposes. An electing passthrough 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.
For more information, contact a KPMG State and Local Tax professional:
Brad Wilhelmson | +1 312 665-2076 | email@example.com
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