Nov 12 The Treasury and IRS Issues Proposed Regulations for Businesses to Deduct State and Local Income Taxes

On November 9, the IRS announced Notice 2020-75 which outlined its plans to permit pass-through entities to deduct state and local taxes from their taxable income calculations.  This Notices clarifies tax positions for individual taxpayers and how they report tax for federal income tax purposes.

The Tax Cuts and Jobs Act of 2017 limited an individual taxpayer’s deduction for state and local taxes to $10,000 per year.  Following that federal law change, a number of states enacted work arounds to create expenses which would remain deductible for federal income tax purposes, yet not create additional state tax burdens on their residents.  The IRS issued guidance that state work arounds would be scrutinized; several regimes related to charitable contributions or employment-based taxes have already been scrapped because of the IRS’s disapproval.

Several states, including Connecticut and New Jersey, created taxes for pass-through entities (e.g., partnerships, LLCs, S Corps) which would be paid by the entity and credited to its owners (e.g., partners, members, shareholders).  These taxes were similar to entity-level taxes which pre-dated the TCJA, such as New York City’s Unincorporated Business Tax.  This recent announcement confirms that the latest pass-through entity tax regimes will achieve the desired result of creating deductible state tax expenses for its individual owners.

The Notice also made clear that the IRS intends to treat elective taxes (e.g., New Jersey’s Business Alternative Income Tax) in the same way it treats mandatory taxes (e.g., Connecticut’s Pass-Through Entity Tax).  The elective nature of the tax is not determinative of the IRS’s treatment.  While the proposed regulations are forthcoming, taxpayers may rely on this recent Notice.

Based on this Notice, taxpayers electing to pay the New Jersey BAIT should expect the entity’s deduction for state taxes will be respected, without limitation, by the IRS.  Cash-basis taxpayers should be careful to make their BAIT payments before the end of the year to ensure their deduction.

Sax will continue to update you as further details are made available.  Reach out to your Sax advisor or email [email protected]with questions.  For more and on-going information relative to your state and business, visit Sax’s COVID-19 Resource Center.