However, a few states (most notably New Jersey) have substituted a state tax at the business level. The business pays the state taxes which are allowed as a deduction against federal taxes. That means the individual taxpayer doesn’t have to pay them and thus they don’t run into the SALT $10,000 limitation.
In theory, that was how it was supposed to work.
But we all waited to see if the IRS was going to allow that strategy to stand. Could this be a workaround for business owners who ran into the SALT limitation deduction on their personal return?
So far, the IRS had been quiet about whether they would allow the strategy and then on Monday, 11/9/2020, they broke their silence.
They will be releasing regulations this next week that will “clarify that state and local income taxes imposed on and paid by a pass-through entity are allowed as a deduction by the pass-through entity in computing its non-separately stated taxable income or loss for the taxable year of payment.”
Moreover, the agencies said pass-throughs can rely on the upcoming proposed regulations starting Monday. Pass-throughs can apply the upcoming rules to certain income taxes paid beginning with the 2018 tax year and before the date the proposed regulations are published in the Federal Register.
So far, seven states have adopted an entity-level tax on pass-throughs in which the state tax paid generates a federal deduction at the entity level and, in some states, a state tax credit at the partner level. Other states do not offer the credit, but the partners can exclude that portion of income that was subject to the entity tax.
“The Treasury Department and the IRS are aware that there is uncertainty” about the pass-through taxes, the agencies said in their notice. “The Treasury Department and the IRS intend to issue proposed regulations to provide certainty to individual owners of partnerships and S corporations in calculating their SALT deduction limitations.”
We will be watching this closely. If the regulations come out as we expect them to, you will want to have your pass-through entity pay state income tax directly. This should not pass through to the individual partners.