As part of the 2017 Tax Cuts and Jobs Act, the deduction for state and local taxes was severely limited. As a response to the limitation, New Jersey passed legislation that allows eligible pass-through entities (PTEs), such as S corporations and partnerships, to compute and pay New Jersey tax on its business income at the entity level. This program, known as the Business Alternative Income Tax (BAIT) was developed as an alternative to the loss of the deduction for state and local taxes and to put owners of PTEs on a similar footing with C corporations which were unaffected by the change in federal law. For background information on the New Jersey BAIT, see our prior alert here. One of the concerns with the legislation was whether the IRS would respect the BAIT as an entity-level tax and allow the deduction in computing federal taxable income. This concern arose because the PTE owners are entitled to receive a credit against their New Jersey tax liability for their allocable portion of the BAIT paid by the entity.
Late last evening the Internal Revenue Service issued Notice 2020-75 announcing its intention to issue proposed regulations clarifying that state and local income taxes imposed on and paid by certain pass-through entities (PTEs) will be allowed as a deduction in computing separately stated taxable income.
The forthcoming proposed regulations will clarify that “Specified Income Tax Payments” will be deductible by partnerships and S corporations in computing their federal taxable income. For these purposes, a Specified Income Tax Payment is defined as an amount that paid by a partnership or an S corporation to a State (including a political subdivision of a State) or the District of Columbia which satisfies its liability for income taxes imposed by the jurisdiction on the entity.
As indicated in our previous alerts the New Jersey BAIT is an elective provision. Notice 2020-75 provides that the deduction for Specified Income Tax Payments, such as the New Jersey BAIT, should be allowed without regard to whether the tax is imposed as a result of an election by the entity or whether the partners or shareholders receive a credit or other tax benefit based on their share of the entity level tax paid.
While the general rules of deductibility for state and local income taxes under Section 164(a) of the Internal Revenue Code provides for the deduction of taxes paid or accrued during a taxable year, Notice 2020-75 states that the deduction of the Specified Income Tax Payments will be allowed for amounts paid during its taxable year. This rule appears to apply for both cash and accrual basis taxpayers as there is no mention of accrued taxes being allowed as a deduction in the notice.
As a follow up to our recent alert here discussing year-end tax planning considerations for New Jersey PTEs, now that we have certainty regarding the allowance of the deduction for BAIT payments, eligible businesses should consider starting their year-end tax planning process now to understand the impact of making entity level tax payments on their federal taxable income. While some entities may have sufficient cash to make meaningful payments, others may wish to consider borrowing funds.
Please contact your WG Advisor if you have questions regarding whether electing to pay the New Jersey BAIT makes sense or if you need help analyzing the impact of such an election.