SALT cap doesn’t apply to state income taxes paid by passthrough entities
The $10,000 cap on state and local taxes (SALT) doesn’t apply to state income taxes paid by passthrough entities.
In news release IR-2020-252 and Notice 2020-75 the IRS clarifies the deductibility of state and local income taxes paid by partnerships and S corporations. Under the guidance, the deduction is included in the passthrough entity’s ordinary income and loss. Partners and shareholders may deduct specified income tax payments; the state and local tax cap (SALT cap) on itemized deductions does not apply to taxes paid and incurred in carrying on a passthrough trade or business activity.
Background on passthrough entity tax return items and the TCJA SALT cap
Partnerships and S corporations report income, deductions, gains, losses, and credits on entity tax returns (Form 1065 or Form 1120-S respectively) and these items are passed through via Schedule K-1 to partners and S corporation shareholders. Partners and shareholders, in turn, report the items on their individual tax returns. An item may be included in the business’s ordinary income or loss, such as the business’s gross receipts and ordinary and necessary business expenses, which is passed through as a single net figure to partners and shareholders. Or, an item may have to be separately stated, such as a capital loss or Section 179 deduction, because the item is subject to the partner’s or shareholder’s own individual limitations.
Another individual limitation is the TCJA’s $10,000 SALT cap ($5,000 if MFJ) on itemized deductions. In some instances, partnerships and S corporations must pay income taxes to state and local governments at the entity level. Passthrough entities questioned whether the entity should passthrough the deduction for these taxes as part of ordinary business income or report the taxes as a separately stated item. If reported as a separately stated item, such treatment could limit deductibility on individual tax returns because of the TCJA’s SALT cap.
Specified tax payments by passthrough entities are not subject to the SALT cap
According to Notice 2020-75, certain state and local jurisdictions have enacted, or are contemplating enacting tax laws that impose either a mandatory or elective entity-level income tax on partnerships and S corporations that either do business in the jurisdiction or have income sourced to the jurisdiction. Some laws also provide for an owner-level state tax benefit, such as a deduction or credit, which the notice acknowledges has created some uncertainty as to whether entity-level payments should be taken into account for the owner-level SALT limitation.
Citing a House committee report to the TCJA, Notice 2020-75 points out that in enacting the SALT limitation (§164(b)(6)), Congress intended that entity-level taxes imposed on passthrough entities and reflected in a partner’s or shareholder’s distributive or pro-rata share of income on Schedule K-1 will continue to reduce the partner’s or shareholder’s distributive or pro-rata share of income as under pre-TCJA law.
The notice concludes that specified tax payments are deductible by partnerships and S corporations in their non-separately stated income and loss.
Definition of specified tax payment
A specified tax payment is any amount paid by a partnership or S corporation to a state, a political subdivision of the state, or to the District of Columbia to satisfy its income tax liability imposed by the domestic jurisdiction on the entity. Taxes paid to foreign governments or to U.S. territories or their political subdivisions do not qualify. The tax may be mandatory or elective. The partners or shareholders may receive some type of state or local tax benefit and the payment may still be treated as a specified tax payment.
Tax treatment of specified tax payments
Specified tax payments are included in the net ordinary business income passed through to partners and shareholders on Schedule K-1. Specified tax payments are not subject to the SALT cap limitation. Partners and S corporation shareholders report ordinary passthrough income in Part II of Schedule E (Form 1040).
However, by statute, taxes paid to foreign governments or to U.S. territories must be separately stated on Schedule K-1.
Effective date and upcoming guidance on passthrough entities and the SALT cap
The guidance in Notice 2020-75 applies to specified tax payments made on or after November 9, 2020. Taxpayers may apply these rules to specified tax payments made during a partnership or S corporation tax year ending after December 31, 2017 and before November 9, 2020 provided the payments were made in accordance with a law enacted prior to November 9, 2020. The Treasury Department and IRS intend to issue proposed regulations incorporating the rules in Notice 2020-75.