Robert S. Schwartz, Esq.
Last fall we wrote about New Jersey and New York’s new legislation purporting to give rise to a federal charitable contribution deduction for payments to certified state or local governmental entities in lieu of paying state income taxes. We noted that the legislation likely amounts to illegal ends around the Internal Revenue Code (“Code”) Section 164 $10,000 limit on federal income tax deductions for state and local taxes. We pointed out that the $10,000 limit began January 1, 2018, and ends via sunset provisions on December 31, 2025. For better or worse, it is now undisputable that the $10,000 limit has in practice (2018) generally increased federal income taxes on successful individuals having high taxable incomes, including owners of businesses operated through “pass-through” legal entities. The pass-through entities most commonly encountered are limited partnerships, limited liability companies and S corporations, although there are a few others.
Historically, pass-through entity federal and state tax treatment has been that the entity’s computed taxable income is passed through to the owners in proportion to their ownership shares. Owners then report and pay federal and state income taxes on their respective shares of entity taxable income at their respective tax brackets. Thus, for example, if a New Jersey active business owner pays $210,000 of New Jersey gross income taxes for 2019 related to his share of “pass-through” entity taxable income, he can deduct on his 2019 federal Form 1040 only $10,000 of that tax liability. At the 37% federal tax bracket, the unavailability of a deduction for $200,000 in New Jersey gross income tax amounts to $74,000 more in federal income taxes.
Consequently, last year emerged New Jersey grass roots efforts to craft New Jersey legislation aimed at avoiding the $10,000 limit in the case of active “pass-through” entity owners. The consequence of these efforts has been enactment of P.L. 2019, c.320, on January 13, 2020, retroactive to tax years beginning January 1, 2020 (Senate Bill No. 3246, as amended December 10, 2019). The legislation is entitled the “Pass-Through Business Alternative Income Tax Act” (the “Act”). As the name implies, New Jersey will impose an income tax on the entity in lieu of its owners paying New Jersey gross income tax on their respective shares of entity taxable income. The tax is elective, not mandatory. In theory, if for 2020 the entity in the above example elects Act tax treatment, the New Jersey active business owner’s share of the entity tax of $210,000 reduces his or her share of federal “pass-through” taxable income by $210,000. Put another way, the Act’s targeted federal tax effect is “as if” the owner got a $210,000 personal federal income tax deduction for $210,000 worth of New Jersey income taxes.
In contrast to Connecticut, a review of the Act’s legislative history reveals an apparent legislative intent that the entity tax not amount to more New Jersey taxation of business entity owners than if an elective application of the Act in a particular case had not been made. That is to say, the $210,000 of tax borne by the owner in the example above would be the same with or without the entity electing Act taxation; the only difference is upon whom the tax is imposed. The Act includes an owner tax credit for entity tax paid that is not yet fleshed out by Division of Taxation administrative regulations or Technical Bulletins, and given the Act’s language, it remains to be seen whether or not the apparent legislative intention will prove out in practice. Without intending to sound too technical, we have discerned to date the following questions and considerations that business owners need to address with competent counsel before deciding to elect the new tax:
- Will the U.S. Treasury Department and/or the IRS attack the Act because it appears as being in economic substance the same as owner level New Jersey gross income taxation, except that with elected application of the Act the same amount of New Jersey income taxes avoids the $10,000 limit?
- Is the Act really the same in economic substance as owner level New Jersey gross income taxation? For example, will the Act’s owner level New Jersey gross income tax credit against the owner’s share of the pass-through entity tax, as both are reported on an owner’s New Jersey Form 1040 or Form 1040NR, actually render the pass-through entity state tax cost-neutral to an owner? Will it make a difference to New Jersey resident owners of entities that conduct business in several states deriving income from several states’ sources?
- Which of the Act’s four tax brackets (5.525%, 6.37%, 8.97% or 10.75%) potentially applicable to the pass-through entity must be used to avoid New Jersey underpayment interest on an electing entity’s underpaid quarterly estimated entity tax payments?
- If owners elect the new pass-through entity tax, will they find the conversion too complicated, time consuming and expensive both as to in-house staff time and professional services compared to its likely five-year useful life?
- Passive owners of pass-through entities, who are by definition subject to Code Section 469 passive activity loss deduction limitations, often will not currently receive the federal income tax deduction benefit intended by the Act.
- All owners’ federal tax basis in their pass-through entity ownership interests will not annually increase to the same full extent as it would assuming the pass-through entity tax election is not made. This is because an electing entity will have less federal taxable income in elective years to be allocated among owners so as to increase their respective interests’ federal tax basis by their respective shares of entity taxable income under the long-standing and continuing federal tax basis rules.
- Will the owners’ New Jersey tax basis in their pass-through entity ownership interests annually increase by the amount of the entity tax so that the entity tax does not result in imposition of owner gross income tax on previously paid entity level tax in many or all cases when an owner sells his or her ownership interest?
- How will the entity level tax and tax credit for its payment apply to New Jersey part-year residents and non-residents?
As alluded to above, Division administrative regulations or Technical Bulletins are going to be important to the realization of the Senate and Assembly’s apparently intended tax benefits of the Act. Please do not hesitate to contact Robert S. Schwartz, Esq., at 908-647-1022, or contact him at [email protected] for further knowledge and counsel in connection with income tax planning involving this new elective New Jersey income tax.