IRS Endorses State And Local Tax Deduction Cap Workaround | Rea CPA

IRS Endorses State & Local Tax Deduction Cap Workaround

Endorsement Spells Relief For Pass-Through Entity Owners

Before the 2017 Tax Cuts and Jobs Act (TCJA), the Internal Revenue Code allowed the deduction of applicable state and local taxes without limitation. However, the TCJA capped this benefit at $10,000, meaning that taxpayers who pay more than $10,000 in applicable state and local taxes aren’t able to receive the benefit of the additional tax paid. This cap only applied to state and local taxes paid by individuals and not entity-level taxes. This limitation put owners of pass-through entities at a disadvantage since the majority of state income taxes on pass-through entities are generally not paid at the entity level, but rather by the owner. With the most recent guidance issued by the IRS, pass-through entity owners have the opportunity to get some relief, depending on where they are conducting business.

In impending proposed regulations, Notice 2020-75, released Nov. 9, 2020, the IRS gave their approval to a workaround to the $10,000 cap when it comes to state and local taxes paid by pass-through entities. The IRS plans to issue regulations that clarify that business organized as passthrough entities that pay an entity-level tax can deduct the taxes. Therefore, the taxes wouldn’t be subject to the state and local tax deduction cap on the return of the partner or shareholder at the individual level, while the benefit would still be received by way of lower ordinary income from the entity. The effective date allowing this treatment will be for entity-level taxes paid on or after Nov. 9, 2020. Though, if the state law was enacted prior to this effective date, then the entity level tax deduction will be allowed dating back to the state’s enactment of the entity level tax.

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This release is promising for taxpayers with higher state income tax liabilities, as the IRS has previously rejected or was expected to reject other certain state efforts to help their taxpayers workaround the SALT deduction cap, such as characterizing SALT payments as charitable contributions to the state or income tax credits on payroll taxes paid.

Prior to this acknowledgment of acceptance, a handful of states, including Connecticut, Louisiana, Maryland, New Jersey, Oklahoma, Rhode Island, and Wisconsin have all already adopted entity-level taxes, some of which even offer credits against the owners’ personal tax liability in those states. The new entity-level taxes that have been enacted as a workaround to the state and local deduction cap are elective in every state with the exception of Connecticut, where it is mandatory.  

For Ohio residents who own pass-through entities that may file returns out of state, tax paid to another state includes both amounts reported on the taxpayer’s individual income tax return and amounts paid on the individual taxpayer’s behalf by a pass-through entity on a composite income tax return. While no specific guidance has been issued by the Department of Taxation regarding these new taxes, a pass-through entity electing to be taxed as the entity level may result in losing the ability to claim the resident credit for taxes paid to other states.

By Lamarcus Crowders (Dublin office)

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