In response to the federal $10,000 cap on the state and local tax deduction, New Jersey recently enacted an elective pass-through entity tax. By taxing pass-through entities, the law shifts the tax burden from individuals subject to the federal deduction limitation to entities that are not subject to the limitation, which deduction then flows through to the pass-through entities’ owners without limitation. While uncertainty remains about the federal deductibility of such state pass-through entity taxes by individual owners, New Jersey joins a growing number of states to pass similar legislation in the wake of the SALT deduction cap, including Connecticut, Louisiana, Oklahoma, Rhode Island, and Wisconsin.
Senate Bill No. 3246, signed into law on January 13, 2020, allows pass-through entities, with at least one member who is liable for New Jersey gross income tax, to make an annual election to pay the New Jersey business alternative income tax (“NJAIT”) for tax periods beginning on or after January 1, 2020. The election must be unanimous by the pass-through entity’s members or made by an authorized officer, manager, or member of the electing entity. The election must be made annually and cannot be made retroactively. The marginal tax rate ranges from 5.525% to 10.9%, depending on the amount of distributive proceeds, with quarterly estimated payments generally required. Note that these rates do not match the personal income tax brackets and the election is not available to sole proprietorships or single-member LLCs.
Members of pass-through entities that elect into paying the NJAIT will receive a corresponding credit equal to the member’s pro rata share of the NJAIT paid. Individual members will receive a refundable gross income tax credit and corporate members will receive a corporation business tax credit that may be carried forward if it is greater than the current year tax liability. Moreover, a resident taxpayer is generally allowed to take a credit against the NJAIT to the extent the income is subject to a similar tax imposed by another state.
As taxpayers in states like New Jersey are painfully aware, the 2017 Tax Cuts and Jobs Act instituted a $10,000 SALT deduction cap. For tax years beginning on or after January 1, 2018, individuals may only deduct their state and local taxes up to $10,000 for purposes of calculating their federal income tax liability. The NJAIT offers a potential workaround because the 2017 Tax Cuts and Jobs Act does not explicitly limit the deductibility of pass-through entity taxes. However, in the absence of explicit guidance by the IRS permitting the deductibility of optional pass-through entity taxes, there is risk. The IRS recently published guidance disallowing the deduction for donations made to state charities, which was considered an alternative workaround to the SALT deduction cap. With the rise of pass-through entity taxes, the IRS may seek to limit this workaround as well.
Taxpayers eligible for the NJAIT should weigh this risk against the potential upside in reduced tax liability. Moreover, taxpayers should discuss this tax regime internally with fellow pass-through members, not only because unanimity is required for the election, but also because it may disturb the filing profile of certain members. For example, a non-New Jersey resident with a limited stake in an LLC with operations in New Jersey may currently be taking a no-nexus position in New Jersey. These considerations, as well as the impact on the New Jersey combined group, should be discussed with a trusted adviser.