Notice 2020-75: The IRS Intends to Issue Proposed Regulations to Assist with State and Local Tax (SALT) Deduction Cap
On November 9, 2020, the IRS released Notice 2020-75. With this Notice, the IRS described its intention to issue proposed regulations, in connection with the Treasury Department, which would allow a partnership or an S-corporation for tax purposes to deduct state and local taxes from their non-separately stated taxable income or loss for the tax year of payments. They would not be passed through to the partners or shareholders, where they would then be subject to the Tax Cuts and Jobs Act’s $10,000.00 limitation on state and local tax (“SALT”) deductions.
Internal Revenue Code Section 164(a) provides for the SALT deduction. The SALT cap was provided for by Section 164(b)(6). In response to the Tax Cuts and Jobs Act’s so-called “SALT cap,” many states, including Connecticut, Maryland, New Jersey, Oklahoma, Rhode Island, Wisconsin, and Louisiana, adopted laws which separately attempted to circumvent the “SALT cap” on the state level. For example, in Louisiana, Oklahoma, and Wisconsin, the solution involved entities calculating their tax base and paying state income tax; the partners and shareholders were not assessed a tax liability and were not assessed a distributive share of income for state income tax purposes.
The remaining states mentioned above took a different approach to circumvent the “SALT cap”, the work-around involved the entity paying state income tax, but retaining certain pass-through features; partners and shareholders would then receive a state income tax credit equal to all or a portion of their share of the tax paid by the entity (as an aside, of the states listed, only Connecticut’s entity taxation regime is mandatory).
With the issuance of Notice 2020-75, the IRS has effectively expressed its intent to approve these state-level work-arounds. The intention of the IRS was unclear up until this point, as it had previously shut down SALT deduction work-arounds involving contributions to a charitable state fund via proposed regulations.
In Notice 2020-75, the IRS has confirmed its intention to issue proposed regulations clarifying that state and local income taxes imposed on and paid by partnerships and S-corporations will be allowed to be deducted by the entities themselves. The Notice says that these taxes must be direct income taxes imposed and paid by the entity, and defines them as Specified Income Tax Payments. The Notice further indicates that the proposed regulations will allow an entity a deduction regardless of their state’s regime, be it mandatory or elective.
Additionally, the Notice states that an entity tax does not constitute an item of deduction if a partner or S-corporation shareholder takes into account the partner’s distribution share separately under Sections 702 or 1363. Specified Income Tax Payments, as they are defined by the Notice, also exclude deductions which would be disallowed by IRC Sections 703(a)(2)(B) (Partnerships) or 1363(b)(2) (S-corporations).
Whether the final regulations will be promulgated has yet to be seen. Additionally, there is concern among lawmakers that this arrangement will allow partners in a partnership or shareholders in an S-corporation to be treated more favorably than workers who earn their income through wages, as wage-earners cannot form an LLC and become sub-contractors in order to avail themselves of the deduction. Only S-corporations, partnerships, and LLCs treated as partnerships for tax purposes may take advantage of the proposed changes described by the Notice.
The proposed regulations are intended to apply to tax payments made by an entity on or after November 9, 2020, and Taxpayers may apply the rules in the Notice to Specified Income Tax Payments made in a taxable year of their entity ending after December 31, 2017. If you are a business owner, or are considering forming a business, and have any questions or concerns as to how this new Notice may affect your business taxes, you should not hesitate to reach out to our law firm’s tax professionals for a consultation or further explanation.
VW Contributor: Elena K. Whidden
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