Federal implications of passthrough entity tax elections.

• Author: Mucenski-Keck, Lynn

It has been two years since the IRS stated in Notice 2020-75 that it intended to issue regulations regarding the deductibility of certain state and local income tax payments imposed on passthrough entities (PTEs). However, as of this writing, no such regulations have been issued. Tax practitioners have gone through another tax season without substantive guidance answering critical questions regarding the interaction between PTE taxes and numerous federal tax provisions. In the absence of IRS regulations, tax practitioners are responsible for formulating positions that Notice 2020-75 did not provide.

Background

One of the most significant tax changes for individual taxpayers under the law known as the Tax Cuts and Jobs Act (TCJA), (1) enacted in December 2017, was the $10,000 limitation on the federal deduction for state and local taxes (SALT). Prior to the provision's effective date, for tax years beginning before 2018, and after its scheduled sunset, for tax years beginning after 2025, individual taxpayers may receive a federal income tax deduction for all state and local real property taxes, personal property taxes, state or local taxes, and foreign taxes paid during the tax year, provided they itemize their deductions.

The Joint Committee on Taxation (JCT) estimated that the $10,000 federal limit on the SALT deduction would raise federal revenue by $77.4 billion for the 2019 tax year alone. The JCT also estimated that the $10,000 limit, coupled with the TCJA's almost doubling of the standard deduction, would decrease the number of individual income taxpayers claiming itemized deductions from 46.5 million in 2017 to just over 18 million in 2018--resulting in 88% of households filing tax returns using the increased standard deduction. (2) The federal government would receive a double benefit: additional revenue and simplified tax returns to review under audit.

However, some states were unsupportive of the limitation for fear it would decrease the ability to collect state and local income taxes. States with residents receiving the most value for the SALT deduction prior to the federal limitation included California, Connecticut, Maryland, New Jersey, and New York. (3) These states were also the most active in trying to identify a workaround to allow their residents to receive a full federal SALT deduction.

New York, joined by Connecticut, Maryland, and New Jersey, filed suit against Treasury and the IRS in July 2018, alleging the federal limitation on SALT deductions violated the U.S. Constitution's principles of federalism under the Tenth and Sixteenth amendments, coercing the states to abandon their preferred fiscal policies. On April 19, 2022, the Supreme Court denied a review of the ruling from the Second Circuit, which affirmed the 2019 federal district court decision that the federal SALT deduction limitation did not violate the Tenth Amendment. (4) The Second Circuit noted that Congress surely understood that the limitation on the federal deductibility of SALT would affect some states more adversely than others, and nonetheless, like other federal tax laws, the tax law was within Congress's permissible legislative purpose of influencing, while not compelling, tax policy.

In addition to the lawsuit, representatives from these states pushed for legislation to increase the SALT cap, with one such provision included in the House of Representatives' Build Back Better Act' passed by that chamber in November 2021. The proposal would have increased the SALT cap from $10,000 to $80,000; however, controversy soon arose that the proposed plan would benefit only high-income households. Objections to parts of the House bill by Democratic Sens. Joe Manchin, D-W.Va., Kyrsten Sinema, D-Ariz., and others were ultimately overcome with a substitute amendment that passed in the Senate and was then approved in the House--but without any provision relating to the SALT cap. That legislation was enacted in August 2022 as the Inflation Reduction Act. (6)

At the same time, several states explored workarounds that would allow residents to take a federal SALT deduction with no limitation. One such workaround allowed residents to donate to a local charitable organization and receive a state or local tax credit for the donation amount, anticipating that the federal government would allow the amount to be deemed a charitable itemized deduction. However, the IRS was quick to respond and generally denied this workaround through amending Regs. Sec. 1.170A-1(h)(3), proposed in August 2018 (7) and finalized in June 2019. (8)

With the IRS aggressively targeting attempts to create a SALT cap workaround and with no changes to the limitation coming from the courts or Congress, it seemed increasingly likely that taxpayers would have to wait until after 2025, when the SALT cap is set to expire, to receive a federal deduction related to state income taxes paid due to passthrough activity. However, one workaround seemed to gain legitimacy with the IRS and opened the door for PTEs to claim a SALT deduction.

In November 2020 the IRS released Notice 2020-75, which provided that proposed regulations would be forthcoming, while also clarifying that SALT imposed on and paid by a partnership or S corporation, referred to as specified income tax payments (SITPs), would be allowed as a deduction by the partnership or S corporation in computing its non-separately stated federal taxable income or loss for the tax year of payment. The notice allowed partners and S corporation shareholders to receive a federal deduction for SITPs, resulting in a benefit similar to what was provided to PTE owners prior to the TCJA's $10,000 SALT limitation.

Under Notice 2020-75, an SITP was defined as any amount paid by a partnership or S corporation to a state, political subdivision of a state, or the District of Columbia to satisfy its liability for income taxes imposed by the domestic jurisdiction. The imposition of the state income tax can be a result of an election. In addition, PTE owners can receive a partial or full state deduction, exclusion, credit, or other tax benefit that is based on their share of the amount paid by the partnership or S corporation.

The IRS's notice provided comfort for a variety of states to finalize legislation allowing state income taxes to be paid by the PTE, while providing a federal...