In 2020 we wrote a similar short piece raising a number of issues with New Jersey’s new Pass-Through Business Alternative Income Tax Act, effective for 2020 and subsequent years (the “Act” or “Act Tax”). If the Act Tax is elected, New Jersey imposes an income tax on the New Jersey source taxable incomes of S corporations, general, limited or limited liability partnerships and limited liability companies (together, “pass-through entities”). The policy behind the Act is to set the stage for the owners of pass-through entities to get larger federal income tax deductions for New Jersey income taxes on business taxable income, rather than be limited to a $10,000 per year per owner maximum federal deduction under current federal law. The federal limit of $10,000 per year on deductibility of all state and local taxes paid by individual income tax taxpayers is scheduled to sunset beginning on January 1, 2026, however.
Our earlier writing highlighted among important, unanswered issues whether the U.S. Treasury Department and/or the IRS will attack the Act Tax as a mere “work around” the $10,000 federal deduction limit because the Act Tax’s scheme appears to be the same tax in economic substance as New Jersey’s gross income taxation (“GIT”) of pass-through entity owners on their respective shares of pass-through entity taxable income. GIT taxes are undoubtedly subject to the $10,000 limit. As far back as 2018, the IRS began making public attacks on state “work around” legislation that substitutes for local real property taxes, which are also under the $10,000 limit, state resident elective, cash charitable contributions to state or local governmental entities that the state legislatures reported they intended would avoid the limit.
In early November, 2020, the IRS issued IRS Notice 2020-75 announcing that it is going to issue proposed regulations taking the position that the Act Tax (and tax legislation like the Act in other states, such as Connecticut) will be taken into account at the pass-through entity level in arriving at the amount of pass-through entity taxable income that passes through to owners for federal income tax purposes. This typical IRS way of phasing means that the Act Tax is not subject to the $10,000 deduction limit. In order to understand the implications of the IRS Notice, one must consider at least one example of the Act’s operation and tax consequences. First, consider that during September, 2020, Governor Murphy signed an increase in New Jersey’s GIT effective January 1, 2020 by extending the top 10.75% GIT bracket to New Jersey taxable income over $1,000,000 rather than over $5,000,000. Consider then the GIT results assuming a New Jersey partnership has 2020 New Jersey source taxable income of $10,000,000, and the owners of which are each married, New Jersey residents, and file joint returns. GIT due absent an Act election is as follows:
Owner Ownership Percentages Taxable Income Shares GIT Tax
A (80%) $ 8,000,000 $ 825,157
B (10%) $ 1,000,000 $ 72,657
C (5%) $ 500,000 $ 27,807
D (2 1/2%) $ 250,000 $ 11,882
E (2 1/2%) $ 250,000 $ 11,882
Totals (100%) $10,000,000 $ 949,385
Assuming the partnership elects the Act Tax for 2020 and applying the Act’s tax brackets on pass-through entity taxable income, which trend a little higher than the GIT brackets, but that are not necessarily higher as to a given owner, owner shares of the Act Tax are as follows:
Owner Ownership Percentages Shares of Act Tax
A (80%) $ 778,310
B (10%) $ 97,289
C (5%) $ 48,644
D (2 1/2%) $ 24,322
E (2 1/2%) $ 24,322
Totals (100%) $ 972,887
In addition, one must add to the mix that under the Act each partner who files a New Jersey Form 1040 at least has the opportunity to credit his or her share of Act Tax (but as his or her last New Jersey tax credit allowed for the year) against the GIT tax on his or her share of entity level taxable income and obtain a tax refund. To claim the credit / tax refund one must prepare and file an NJ 1040. In the example, the partnership owes New Jersey income tax of $972,887 and thus New Jersey collects $23,502 more in income taxes on the business than if the Act Tax is not elected, pre-GIT credit however. Also pre-credit, the minority owners have greater proportional tax burdens than the 80% owner. All owners benefit from federal tax savings from the Act, however, because without the Act each would be limited to a $10,000 GIT federal income tax deduction. Although containing a flawed reference, new N.J.S.A. 54A:12-5, however, should allow each owner to receive a non-interest bearing GIT refund of the difference between his or her share of the Act Tax and his or her GIT tax assuming no Act Tax election.
There will likely be federal tax issues concerning entity or owner federal gross income inclusion of owner GIT credit refund receipts that result from owners’ shares of the Act Tax paid being more than the GIT on their respective shares of entity taxable income. The IRS likely will take positions that eliminate or minimize federal tax deductions in excess of New Jersey income taxes paid on the business’s income net of GIT credit refunds. The tax years of Act Tax payments and owner receipts of credit / refunds are not going to be the same adding to complexity. We will not know how many entities or owners will have IRS issues until the IRS looks at a sufficient number of Act Tax 2020 PTE-100 returns together with the owners’ 2020 NJ 1040s. Aside from that, however, the Act appears to us to be income tax neutral or favorable for all pass-through entity owners who are New Jersey residents. This observation is not being made with reference to pass-through entities having both substantial income from New Jersey sources and significant non-New Jersey resident owners. There are a number of complex Act Tax-related issues in those situations regarding non-New Jersey residents.
The Division of Taxation emphasizes in its recent guidance that an election into the Act Tax requires either (1) all owners to consent or (2) a person with authority to make the election. The latter does not mean that the Division will not hold all owners to an autocratic election. The Act Tax election is annually elective. For more information about the Act Tax you may refer to IRS Notice 2020-75, the Division of Taxation website or you may contact Robert S. Schwartz, Esq., at 908-679-5011, extension 112, or at [email protected] for further knowledge and counsel in connection with income tax planning involving this new elective New Jersey income tax.
This writing is not and should not be interpreted as the rendering of legal advice or performance of legal services to any person by Herold Law, P.A. In accordance with professional ethical rules, Herold Law, P.A., renders legal advice and performs legal services only in the context of an attorney-client relationship entered into before rendering advice or performing services.