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IRS to Issue Proposed Regulations for Pass Through Entities

November 24, 2020

The IRS has announced that it will issue proposed regs. clarifying that state and local income taxes may be deducted by a partnership or s corporation and are not subject to the SALT deduction. Here are the details.

Attention business owners…you’ll want to read up on a workaround to the $10,000 cap on the state and local tax (SALT) deduction under the Tax Cuts and Jobs Act (TCJA). We dive in below.

What is the SALT deduction?

Historically, the ability to deduct state and local taxes has been a valuable tax break for those who itemize deductions on their federal tax returns. In the past, you were able to deduct 100% of state and local income or sales taxes. In addition, homeowners could deduct 100% of their state and local property taxes, too. Essentially, if you itemized deductions in the past, there was no limit on the amount of SALT deductions you could take.

The TCJA limits the itemized deductions for personal SALT amounts to a combined total of only $10,000 ($5,000 for married filing separately). The limitation applies to state and local income taxes and property taxes.

What is the workaround?

The IRS has plans to issue proposed regulations that clarify that businesses organized as partnerships and s corporations can exceed the $10,000 limit on state and local tax deductions imposed by the TCJA.

Several states, including CT, NY and RI, have enacted laws to provide alternative federal tax benefits for their residents. For example, CT levies a tax on the pass-through entity on the income of its owners. The pass-through entity receives a deduction against ordinary income for the tax on their federal return, which flows to the owners on Schedule K-1, and the owners get a credit for their share of the tax paid when they file their individual CT return.

In this way, you are able to get a deduction on your 1040 for state taxes paid above and beyond the $10,000 that you are otherwise limited to.

The IRS had not issued guidance on this until earlier this week so the deductibility of the taxes by the entity was still uncertain, as we covered in our blog, https://kahnlitwin.com/blogs/tax-blog/irs-cracks-down-on-salt-deduction-workarounds.

What is the Rhode Island pass-through entity election?

RI allows pass through entities to make an election to pay the 5.99% tax on income of the owners of the entity. The pass through entity is allowed to take a deduction on their federal return for the tax paid. The owners claim a credit for their share of the tax paid by the entity.

Using this election, owners of pass through entities are able to recognize a deduction for their RI taxes through the ordinary income allocated on their Schedule K-1 and still potentially deduct up to $10,000 of other state and local taxes paid as an itemized deduction.

When can you make the election?

The election can be made for tax years beginning on or after January 1, 2019.

What are some potential pitfalls to making the election?

The election is only available for individual owners. If a partnership or s corporation has non-individual owners such as, trusts or other partnerships, then those partners would not be eligible to be included in the election.

Although an elective tax, you are required to make estimated tax payments for this tax throughout the year. Starting to make payments later in the tax year can result in underpayment penalties. For 2020 calendar year taxpayers, first and second quarter payments were due July 15th and third quarter payments were due September 15th.

Now that the IRS has taken their position, we expect that many other states will propose similar taxes.

We’ll keep you posted. Contact us for further guidance.

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