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New Jersey's Governor Signs New Workaround to Address 2017 Tax Act's Limitation on State & Local Tax Deductions

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Gibbons Corporate & Finance News - Legislative Tax Alert

February 5, 2020

New Jersey Governor Phil Murphy signed new legislation on January 13th designed to mitigate the effects of the $10,000 federal cap on certain individuals’ deductions for state and local taxes implemented under the 2017 Tax Act.

Effective for the 2020 taxable year, under the new law (S-3246/A-4807), owners of an interest in pass-through entities (limited partnerships, limited liability companies treated as partnerships for income tax purposes, S corporations, and other business partnerships) can elect to pay their New Jersey state income taxes on their taxable income directly at the entity level as a business tax – rather than at the owner level under the gross income tax or corporation business tax (CBT). In turn, the law allows the owners a corresponding refundable gross income tax or CBT credit. This is an annual election to be made at the entity level, with the consent of either (i) all of the owners or (ii) an authorized officer, manager, or member.

The entity’s New Jersey tax is calculated based on each owner’s pro rata share of the entity’s distributive proceeds for the taxable year. The tax rate is 5.525% if distributive proceeds of the pass-through entity are less than $250,000 for the taxable year; 6.37%, if the distributive proceeds are less than $1,000,000, but greater than or equal to $250,000 in the taxable year; 8.97%, if the distributive proceeds are less than $3,000,000, but greater than or equal to $1,000,000 in the taxable year; or 10.75%, if the distributive proceeds are greater than or equal to $3,000,000 in the taxable year. These rates are scheduled to increase slightly in future years.

For each pass-through entity in which the taxpayer has an ownership interest, the amount of the credit is equal to the owner’s pro rata share of the entity-level tax paid, which credit shall be applied against the gross income tax liability of the individual owner in the taxable year, or for corporate owners, against the corporation’s CBT liability.

There are about 175,000 LLCs taxed as partnerships and an estimated 115,000 New Jersey businesses registered as S corporations, the owners of which could elect into the benefits of this law. According to the most recently available statistics published by the NJ Division of Taxation (2015) for full-year resident returns, New Jersey partnerships reported gross income of $23.4 billion and S corporations reported gross income of $11.9 billion, out of a total of $358.2 billion New Jersey GIT taxable income.

While the law as drafted could be construed to include sole proprietorships, in particular those organized as single-member LLCs (which are disregarded entities for tax purposes), it is difficult to determine how that would work in practice as there are currently no entity-level income tax filings or information returns for these entity types on which such entities could report income and elect into the new law. If such entities cannot make an election into the entity-level tax structure, (i) an owner of a single-member LLC may want to consider adding a member to convert the entity into a partnership that files an information return, and (ii) a sole proprietor may want to consider converting to a flow-through business entity and adding a partner, or making an S election, so as to take advantage of this new legislation.

Although a number of states have adopted legislation intended to circumvent the 2017 Tax Act’s limitation on the deduction of personal state income taxes, the IRS has successfully blocked all of the numerous attempts to date. Sponsors of New Jersey S-3246 believe it should succeed because the 2017 Tax Act and federal law generally place no limit on the deduction of state and local taxes for businesses. Despite this favorable initial view, it is difficult to handicap the extent to which New Jersey’s workaround will survive any IRS or Treasury Department attempt to quash it.

We would be happy to talk with current and potential clients who have questions on the new legislation, and on federal or New Jersey taxation in general.