It used to be that taxpayers who itemized their deductions were permitted to deduct the entire value of their state and local tax payments from their federal income and thereby reduce their federal income tax liability. This state and local tax (“SALT”) deduction was severely restricted by the Tax Cuts and Jobs Act (“TCJA”) for tax years 2018 and later. Under the TCJA, the SALT deduction is capped at $10,000. The cost of this limitation is predominantly borne by high tax states like California and New York which are mostly Democratic voting states. Although many taxpayers in these blue states are better off than they were before the SALT cap due to lower rates and other reforms introduced by the TCJA, many of the states most affected by the SALT cap have sought to develop workarounds to retain the previously unlimited deductibility of state and local taxes.
The most common strategy for a workaround of the cap was to establish government-linked charitable funds, allowing taxpayers to make a voluntary contribution to the state charity and then claim a charitable deduction and obtain a tax credit to be used to reduce their state tax liability. This all sounded good in theory, but the IRS had other ideas. In 2019, they issued a notice pointing out that forthcoming guidance would be based on the well-established principle of “substance over form,” meaning that a state may call a payment a charitable contribution, but that does not make it a charitable contribution when it is made in satisfaction of a tax liability. So the states had to go back to the drawing board.
States started to look for a possible workaround based on an entity level tax. Connecticut was the first to take this route and was soon followed by New Jersey and a few other states. They introduced an income tax which applies to pass-through entities such as partnerships or S corporations rather than to the equity holders in partnerships or S corporations. Because the tax is at the entity level, the theory is that the entity level tax should be fully deductible at the federal level without regard to the individual limitation. These states then provided a personal tax credit to the individual equity holders in the pass-through entities, which could be set against the individual equity holder’s state tax liabilities. Many tax professionals waited for the IRS to strike this entity level tax down as being no more than a fiction designed to get around the SALT cap. However, on November 9, 2020, the IRS issued Notice 2020-75 which effectively approved the flow-through SALT cap workaround.
The Notice states that the government intends “to issue proposed regulations to clarify that state and local income taxes imposed on and paid by a partnership or an S corporation on its income, are allowed as a deduction by the partnership or S corporation in computing its non-separately stated taxable income or loss for the taxable year of payment.” Only a “Specified Income Tax Payment” is deductible, and this is defined as “any amount paid by a partnership or an S corporation to a state, a political subdivision of a state, or the District of Columbia (Domestic Jurisdiction) to satisfy its liability for income taxes imposed by the Domestic Jurisdiction on the partnership or the S corporation.” In this way, the entity’s tax payment would be reflected in an individual partner’s or shareholder’s distributive or pro-rata share of non-separately stated income or loss reported on a Schedule K-1. According to the IRS, this indirect equity holder tax benefit would not be used in calculating the SALT deduction limitation of $10,000 for the individual partner or shareholder.
A state must pass a specific statute providing for pass-through entity level taxation in order for this Notice to apply. Merely allowing a pass-through entity to make tax payments on behalf of owners will not qualify because those tax payments are treated as payments made by the owners and not as payments in satisfaction of the pass-through entity’s tax liability. To comply with IRS Notice 2020-75, New York state introduced in 2021 an entity level income tax designed to get around the SALT cap and stay within the requirements of the Notice. A flow-through entity in New York must, for each tax year, irrevocably elect by March 15 to be subject to the entity level tax. For the 2021 tax year only, an election must be made by October 15, 2021. Electing entities are required to make four equal estimated tax payments for every quarter of the calendar year. In order to avoid penalties, an electing entity’s total payments should be the lesser of 90% of the current year’s tax or 100% of the prior year’s tax.
New York’s tax is imposed on the partnership or the S corporation’s taxable income at the following tax rates:
A tax credit is available for a direct partner or shareholder of an electing entity. The credit for partner or shareholder is equal to his or her share of the pass-through tax paid. If the credit exceeds tax due for the taxable year, it should be treated as an overpayment, which can be credited or refunded, without interest. The flow-through tax is deductible in computing the individual partner or shareholder’s federal taxable income, but it is not allowed as a deduction in computing such individual partner or shareholder’s New York State taxable income. Any sole trader or individual single member of an LLC should seriously consider adding a partner, such as a spouse or child, to obtain the benefits of being a multi-member pass-through entity.
This workaround, while a step in the right direction for some residents of high tax states, only applies to partners in a partnership and to shareholders of an S corporation. It does nothing to reduce the impact of the cap on higher-paid employees who live or work in those states.
One issue to be addressed is how an entity level tax credit will work for partners or shareholders of flow-through entities with business operations in multiple states. For example, will all states treat entity level taxes as creditable for purposes of resident income taxes, or will nonresident partners and shareholders be disadvantaged by the resident credit rules of non-flow-through workaround states? The New York state law does provide for a tax credit to be available to a New York resident partner or shareholder for their share of any pass-through entity tax imposed by another state upon the entity’s income derived from that state. In this way, the partners and shareholders are permitted to indirectly deduct the SALT taxes paid by their pass-through.
You may be impressed that states are working to ensure that their residents are not double taxed due to the SALT cap; however, while many of these high tax states work to prevent double taxation by the federal government, they are also working to double tax workers who fled their offices and the states that those offices are in. States can tax income where workers live and where they work, and some states may also tax the income of workers even if they neither live nor work in that state. We are undoubtedly going to see cash-strapped states taking more aggressive positions as a result of more Americans working remotely both during the pandemic and after it. This is likely to lead to some nasty surprises for many remote-working employees.
Seven states tax employees in the state where their office is located even if those employees do not actually work in that state, and these individuals may be denied their home state’s credit for taxes paid to another state, exposing them to double taxation. Arkansas, Connecticut, Delaware, Nebraska, New York, and Pennsylvania had implemented what is known as “convenience rules” prior to the pandemic, while Massachusetts adopted a supposedly temporary income sourcing rule with the same effect in response to pandemic remote working. The convenience rule states that if an employee’s job is based with an employer in one state, but he or she lives and works in another state for ‘convenience’ rather than because the employer requires the employee to work offsite, then that employee owes income tax to the state where the job is based.
For example: Employee A has a job with an employer based in New York city and Employee A has an office available to them in New York city where they worked pre-pandemic, but Employee A now chooses to work remotely from their home in Maine. Under the convenience rule, Employee A will still owe full income tax to New York on remuneration earned from the New York-based job even though Employee A never set foot in New York in the tax year. If Maine taxes that remuneration income and does not give a credit for the tax levied by New York on the same income, then Employee A will be double taxed. This could have an adverse effect on long-term competitiveness, as telework-friendly businesses are faced with either 1) remaining in these convenience rule states, but having difficulty keeping and recruiting staff who wish to work remotely or 2) going to the expense of moving their offices elsewhere to avoid subjecting their employees to double taxation.
The convenience rule’s constitutionality is going to be tested in the case of New Hampshire v. Massachusetts in which New Hampshire is challenging Massachusetts’ practice of taxing nonresidents who previously worked in-state, but now work remotely from home in New Hampshire. It is likely that the US Supreme Court will get involved. Many employees who wish to work remotely out of the state where their job is officially based will be watching this case very closely.
If you have any further questions regarding pass-through entity taxation or double taxation issues, please contact Ian Shane.