The Internal Revenue Service (the “IRS”) announced in Notice 2020-75 (the “Notice”) that it is adopting a permissive position on the deductibility of certain state and local income taxes paid by a partnership or S corporation (collectively, “Pass-through Entities”) without regard to whether individual partners or S corporation shareholders of such Pass-through Entity (collectively, “Individual Owners”) receive a corresponding state or local tax benefit for their share of such taxes. The Notice provides welcome clarity for Individual Owners of Pass-through Entities conducting business in certain states, including Connecticut and New Jersey.
Section 164(b)(6) of the Internal Revenue Code, enacted as part of the Tax Cuts and Jobs Act of 2017, generally limits the deduction of an individual for certain state and local taxes to $10,000 per taxable year (the “SALT Limitation”).[1] Enactment of the SALT Limitation placed Pass-through Entities and their Individual Owners at a disadvantage as compared to C corporations, since state taxes on a Pass-Through Entity’s income generally are paid by the entity’s owners, and therefore the deductibility of state taxes on such income that is paid by the entity’s Individual Owners would be limited. Some states (including Connecticut and New Jersey) have enacted an entity-level income tax on Pass-through Entities with a corresponding tax credit to the entity’s owners, which can provide a significant state tax benefit to Individual Owners, especially those that are also residents of such state. Prior to the Notice, whether the IRS would accept the deductibility of this type of entity-level tax was unclear, with some suggesting that the IRS might seek to treat such taxes as a payment by the Pass-through Entity of its owners’ tax liabilities, which for Individual Owners are subject to the SALT Limitation.
The Notice provides much greater certainty on this issue in a way that is largely favorable to individual taxpayers, with immediate and potentially retroactive effect. The forthcoming proposed regulations announced in the Notice will provide that “Specified Income Tax Payments” are deductible by Pass-through Entities in computing their non-separately stated taxable income. For these purposes, a Specified Income Tax Payment means any amount paid by a Pass-through Entity to a state, a political subdivision of a state, or the District of Columbia to satisfy its liability for income taxes imposed on the Pass-through Entity.[2] A Specified Income Tax Payment includes any amount paid by a Pass-through Entity pursuant to a direct imposition of state income tax on the Pass-through Entity, without regard to whether the imposition of liability for the income tax is the result of an election by the entity[3] or whether the Pass-through Entity’s owners receive a deduction, exclusion, credit or other tax benefit based on their share of the amount paid by the Pass-through Entity to satisfy such liability. A Pass-through Entity that makes a Specified Income Tax Payment during a taxable year is allowed a deduction in computing its taxable income for such taxable year, and a Specified Income Tax Payment is not treated as an item of deduction that an owner of a Pass-through Entity must take into account separately in determining such person’s federal income tax liability. Instead, the Specified Income Tax Payment is reflected in the partner’s or shareholder’s distributive or pro-rata share of non-separately stated income or loss reported on a Schedule K-1 and is not taken into account in applying the SALT Limitation to an Individual Owner of a Pass-through Entity.
The Notice applies to Specified Income Tax Payments made on or after November 9, 2020, and its rules may also be applied by taxpayers to Specified Income Tax Payments made prior to November 9, 2020 by a partnership or S corporation in a taxable year ending after December 31, 2017 to satisfy a liability for state income tax imposed on the Pass-through Entity pursuant to a law enacted prior to November 9, 2020. Taxpayers are permitted to rely on the Notice prior to issuance of the forthcoming proposed regulations.
If you have questions about the Notice or its application or implications, please contact Seth Lebowitz at 212-573-8152 or slebowitz@sadis.com.
[1] For the sake of brevity, state and local taxes are referred to herein simply as “state” taxes. [2] Specified Income Tax Payment does not include taxes imposed by U.S. territories or their political subdivisions. [3] Some of the currently in force state entity-level income taxes are mandatory, and others are elective.
