New Jersey Enacts Pass-Through Entity SALT Cap

The “workaround train” keeps rolling! A New Jersey bill to give small businesses and partnerships a way to diminish the impact of the federal cap on state and local tax deductions (the SALT cap) was signed into law on January 13, 2020 by Governor Phil Murphy (D). The bill (S-3246/A-4807) gives S corporations, limited liability corporations and other business partnerships the option of paying state income tax directly at the entity level, as a business tax rather than at the partner level, as personal income tax. The bill is effective for tax years beginning on or after January 1, 2020 and creates a business alternative income tax (BAIT). As we’ve outlined in the past, the play here arises because while the Tax Cuts and Jobs Act (TCJA) capped federal deductions for state and local tax at $10,000 for individuals, it set no limit on deductions for state and local taxes paid by businesses.

Mechanics of the Pass-Through Election

For those of you not familiar with pass-through entity (PTE) taxes like this, we covered them here. Essentially, a pass-through entity with at least one member who is liable for New Jersey gross income tax (GIT) may elect to be liable for, and pay, a pass-through business alternative income tax in the tax year. The election to pay tax at the entity level is available if consent is made by each member of the electing entity who is a member at the time the election is filed, or by any officer, manager or member of the electing entity who is authorized, under law or the entity’s organizational documents, to make the election and who represents to having such authorization under penalties of perjury. This election must be made annually on or before the due date of the entity’s return and on forms prescribed by the New Jersey Division of Taxation (DOT). This election may not be made retroactively. If the members decide to revoke an election, that revocation must occur on or before the due date of the entity’s return.

Under the new legislation, the tax imposed on a pass-through entity will be equal to each member’s share of distributive proceeds attributable to the pass-through entity for the tax year, multiplied by the applicable tax rates, designed to mirror what the member’s individual tax rate would have been.

Pass-through entities whose members have made the BAIT election must file an entity tax return and make payments on or before the 15th day of the third month following the close of each entity’s taxable year for federal income tax purposes. Because businesses pay estimated taxes during the tax year, ideally, to avoid the underpayment of estimated taxes, the decision of whether to elect into the BAIT should be made early in the tax year.

Credits

Each non-corporate member of the pass-through entity will receive a credit that is equal to the member's pro rata share of the tax paid by the pass-through entity. If the credit exceeds the amount due, the excess is refundable. Corporate members will be allowed a tax credit against both the corporate business tax and the surtax. However, the credit for corporate members may not reduce the corporate member’s tax liability below the statutory minimum tax. Any excess credit may be carried over for a period of up to 20 privilege periods. A resident taxpayer will be allowed a credit against the gross income tax due for the amount of any tax that the New Jersey DOT determines is substantially similar to this tax by another state of the United States or political subdivision of such state, or by the District of Columbia, with respect to the direct and indirect distributive proceeds from a pass-through entity, which distributive proceeds are also subject to tax. A credit allowed may not exceed what would have been allowed if the income was taxed at the individual level and not taxed at the entity level.

Implications

The bill differs significantly from similar legislation and PTE taxes enacted in other states (e.g., the Connecticut PTE tax) because the BAIT here is elective rather than mandatory. It is unclear whether the elective nature of the BAIT affects its effectiveness as a workaround to the federal SALT deduction cap. For the workaround to achieve its intended purpose, the IRS would have to find that the voluntary nature of the election does not affect deductibility at the trade or business level as opposed to the individual level.

IRS Response

Two states had these pass-through rules in place for 2018 (Connecticut and Wisconsin) and since then three more states have followed suit (Louisiana, Oklahoma and Rhode Island). While the IRS has taken action against the tax credits with regulations and other guidance, the IRS has not issued any formal guidance on these workarounds. However, New Jersey Senate sponsors of this bill have dubbed the legislation “IRS-proof.”  State Senator Paul Sarlo (D) said in a statement, “This provides a ‘Back to the Future’ solution to the federal cap on SALT deductions for potentially hundreds of thousands of small business owners and partners. It would be hard for the IRS to challenge our state’s prerogative to return to a tax system that was in place for 17 years.”

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