LawFlash

NJ Enacts Elective Pass-Through Business Tax to Limit Federal Cap Impact on SALT Deduction

February 10, 2020

New Jersey recently enacted the “Pass-Through Business Alternative Income Tax Act,” which allows pass-through businesses with at least one member liable for the New Jersey gross income tax to make an election to pay income taxes at the entity level, and allows members to claim a refundable credit for their pro rata share of the tax paid.

Under federal tax legislation commonly referred to as the “Tax Cuts and Jobs Act,” individual and married taxpayers filing jointly who itemize deductions may now deduct only up to $10,000 annually for state and local taxes on their federal returns (SALT cap). In response, several states have adopted state-level measures to limit the impact of the SALT cap. The most recent of such measures is New Jersey’s “Pass-Through Business Alternative Income Tax Act” (the Act),[1] which Governor Phil Murphy signed into law on January 13. The Act establishes an elective entity-level tax to be paid by New Jersey pass-through businesses, and provides an offsetting credit to taxpayers who receive pass-through income from the business. Since the Act allows pass-through businesses to pay an entity-level tax, the SALT cap, which applies only to individual taxpayers, would not apply. New Jersey joins several other states, including Connecticut, Louisiana, and Rhode Island in enacting an entity-level tax on pass-through businesses as a measure to limit the impact of the SALT cap.

Mechanics of the Election

Effective for tax years beginning on or after January 1, 2020, the Act allows New Jersey pass-through businesses with at least one member liable for the New Jersey gross income tax to make an election to pay taxes at the entity level. Pass-through businesses include partnerships, limited liability companies that are not taxed as incorporated entities, and S-corporations.

The election is made by the business on an annual basis on or before the due date of the entity’s return on forms to be prescribed by the New Jersey Division of Taxation. The election may be made only if each member, or an officer, manager, or member of the entity with the authority to make such an election consents. The election may not be made retroactively. After an election is made, the business is required to file an entity-level tax return and pay any tax due on or before the fifth day of the third month following the close of the business's taxable year for federal income tax purposes (it is unclear whether this is the extended due date or the original due date). In addition, the entity must make quarterly estimated tax payments throughout the taxable year. If the members decide to revoke an election, the revocation must occur on or before the due date of the entity’s return.

Entity-Level Tax and Refundable Credit

Once an election is made, the electing pass-through business will be subject to a tax that is equal to each member’s share of distributive proceeds attributable to the pass-through business for the tax year, multiplied by the applicable tax rates. The applicable tax rates are designed to generally parallel the member’s individual New Jersey tax rate. Non-corporate members of an electing pass-through business may then claim a refundable credit that is equal to the member’s pro rata share of the tax paid by the business on their personal returns. Corporate members may claim a similar tax credit against their corporate business tax liability; however, this credit may not reduce a corporate member’s tax liability below the statutory minimum tax, and any excess credit may be carried forward for up to 20 years.

Practical Considerations and Concerns

The Act leaves open a number of issues, and further guidance from New Jersey is needed. For example, the Act specifically provides that resident taxpayers are allowed a credit against their New Jersey tax liability for similar entity-level taxes in other states. However, it remains to be seen how this credit interacts with other jurisdictions’ resident credits. There is no guidance for the situation where a New York State resident taxpayer is a member of a New Jersey pass-through business that elects to pay the entity tax. Will New Jersey permit such a taxpayer to utilize their pro rata share of the New Jersey entity tax to offset any New York State resident tax liability?

Further, it is unclear how the Internal Revenue Service (IRS) will respond to the Act and other similar measures enacted in other states. While the IRS has yet to address the deductibility of state entity-level taxes, it is possible that the IRS will challenge such taxes consistent with its response to other state actions that it perceived to be an attempt to circumvent the SALT cap. As with all tax-saving strategies, there is always some level of risk involved.

We will continue to monitor the impact of the Act and provide further information on material developments.

Contacts

If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:

New York
Cosimo A. Zavaglia
Ester Lee

Philadelphia
Justin D. Cupples

 


[1] S.B. 3246.