On November 9, 2020, the IRS issued Notice 2020-75 (the “Notice”), which announced that the IRS intends to issue proposed regulations to clarify that state and local income taxes (“SALT”) imposed on and paid by a partnership or an S corporation, such as Connecticut’s Pass-through Entity Tax, are deductible by the partnership or S corporation in computing non-separately stated taxable income for the year of the payment, and therefore are not subject to the SALT deduction limitation for partners and shareholders who itemize deductions.
SALT Deduction Limit
The federal Tax Cuts and Jobs Act of 2017 placed a limit on the amount of SALT an individual can deduct for regular federal income tax purposes. Generally, an individual’s federal SALT deduction is limited to $10,000 ($5,000 for married individuals who file separate returns) for taxable years beginning after December 31, 2017, and before January 1, 2026.
New Pass-Through Entity Tax (“PET Tax”) and SALT Deduction Limit
In response to these federal limitations, various states, including Connecticut, enacted an entity-level income tax on partnerships and S corporations that do business in the jurisdiction or have income derived from or connected with sources within the jurisdiction. In certain instances, including Connecticut, the jurisdiction’s tax law provides a corresponding or offsetting, owner-level tax benefit, such as a full or partial credit, deduction, or exclusion. Prior to the issuance of the Notice, there has been uncertainty as to whether the entity-level payments of such taxes must be taken into account in applying an owner’s SALT deduction limit.
Specified Income Tax Payments
The Notice indicates that proposed regulations will be issued which will clarify that “Specified Income Tax Payments” are deductible by partnerships and S corporations in computing their non-separately stated income or loss. A “Specified Income Tax Payment” is any amount paid by a partnership or an S corporation to satisfy the entity’s liability for income taxes imposed by and paid to a state, a state’s political subdivision, or the District of Columbia, however, it does not include taxes imposed by U.S. territories or their political subdivisions. This definition applies regardless of whether the tax results from an election by the entity, or whether an owner receives any deduction, exclusion or credit for the payment.
The partnership or S corporation can deduct “Specified Income Tax Payments” in computing taxable income for the year the payment is made. The “Specified Income Tax Payments” will be reflected in a partner’s or a shareholder’s distributive or pro-rata share of non-separately stated income or loss. Lastly, a “Specified Income Tax Payment” made by a partnership or an S corporation is not taken into account in applying the SALT deduction limitation to any individual who is a partner in the partnership or a shareholder of the S corporation.
In past blog posts, we have described Connecticut’s Pass-Through Entity Tax which you can find here and here. However, to date, there has been some uncertainty regarding whether the IRS would attempt to disallow the deduction taken by the partnership or S corporation of the PET Tax. The release of the Notice eliminates any uncertainty with regard to this issue, which is welcome news to all affected taxpayers.
This blog will be updated when more information is available.