Editor: Mary Van Leuven, J.D., LL.M.
The law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, limits the amount of state and local income, property, and sales taxes that individual taxpayers may deduct for federal income tax purposes for tax years 2018 through 2025. Sec. 164(b)(6) allows individual filers a deduction of not more than $10,000 (or $5,000 for a married individual filing separately). Governors and other state leaders publicly said that the change increases the effective tax for residents who, in the past, benefited from state tax deductions that were higher than the new federal limitation.
State tax credit for charitable contributions
State leaders did not sit idly by, but began working on plans to eliminate or mitigate the impact of this federal change. One category of plans involved state tax credits for contributions made to a state or local charitable organization. While some programs predate the TCJA, others enacted during 2018 were in response to the new Sec. 164(b)(6) limitation. These plans, which were proposed in at least nine states and enacted in at least four, allow residents to make contributions to a state or local organization, such as a state charitable contribution fund, in exchange for either a full or partial tax credit that can be taken against state or local income taxes. The aim was to shift a nondeductible state tax liability over $10,000 to a fully deductible charitable contribution.
In August 2018, Treasury announced its response to these plans in proposed regulations (REG-112176-18): For contributions exceeding a de minimis threshold, when a taxpayer transfers payments or property directly to or for the use of a state, "the amount of the taxpayer's [federal] charitable contribution deduction . . . [would be] reduced by the amount of any state or local tax credit that the taxpayer receives or expects to receive in consideration for the taxpayer's payment or transfer." An example posted on the IRS website is illustrative. Suppose a state grants a 70% state tax credit and a taxpayer pays $1,000 to an eligible entity and receives a $700 state tax credit. On its federal income tax return, the taxpayer would be required to reduce the $1,000 contribution by the $700 state tax credit, leaving a $300 allowable contribution deduction.
Some state leaders became more hesitant to push for these plans after the proposed regulations were issued; for example, California's governor vetoed a charitable contribution plan bill in September 2018, explaining that "this measure started as a bold idea, but because of adverse changes in the federal tax law, it now confuses an already complicated scheme and could invite intervention by the [IRS]" (Gov. Edmund G. Brown Jr., veto message to the California State Senate (Sept. 29, 2018)). Accordingly, states that enacted similar legislation in hopes of alleviating residents' increased federal income tax liabilities may be left searching for alternative plans.
Passthrough entity income tax plan
One alternative, which was adopted by two states and is currently under consideration by several others, is a passthrough entity (PTE) tax plan. The intended benefit of these plans is to sidestep the new federal Sec. 164(b)(6) limitation, which may not apply to income taxes imposed on a PTE. Correspondingly, PTE owners may have their filing requirements waived or be entitled to full or partial tax credits to offset their state individual income tax liability.
So far, neither the IRS nor Treasury has issued formal guidance on whether the new state-level PTE tax plans would pass muster as deductible and not limited by Sec. 164(b)(6). IRS officials are aware of these types of plans, but it is currently unknown if regulations or other guidance will be issued to address them. PTE tax plan supporters point to footnote 296 in the Joint Committee on Taxation's Bluebook, which states:
[T]axes imposed at the entity level, such as a business tax imposed on pass-through entities, that are reflected in a partner's or S corporation shareholder's distributive or pro rata share of income or loss on a Schedule K-1 (or similar form), will continue to reduce such partner's or shareholder's distributive or pro rata share of income as under prior law. [Joint Committee on Taxation, General Explanation of Public Law 115-97 (JCS-1-18), p. 68 (December 2018)]
Connecticut and Wisconsin enacted PTE tax plans in 2018. Consider a brief overview of the approaches taken by these two states and some of the more meaningful variations between the laws.
Overview of Connecticut Senate Bill 11
Prior to the enactment of S.B. 11, Connecticut had not imposed an income tax on PTEs since the early 1980s. Before S.B. 11, Connecticut required a composite tax on nonresident, noncorporate owners, and on owners that were PTEs when the owner's share of Connecticut income was at least $1,000; this system only required payments on behalf of certain owners, and its mechanics were similar to nonresident withholding requirements in other states. S.B. 11 created a mandatory 6.99% income tax on PTEs and rendered inactive the composite return requirements, effective for tax year 2018. The new tax applies to each affected business entity (ABE), defined as entities treated as partnerships (other than publicly traded partnerships) or S corporations that are required to file a Connecticut return.
The standard tax base for partnerships starts with Sec. 702(a) separately and nonseparately stated items, then applies state-specific modifications, and finally sources the sum to Connecticut. This tax is codified in the individual tax code and, as such, the related sourcing rules would likely apply. The ABE can elect to use an alternative base computed by applying ratios reflective of ownership by individuals or trusts. If the base is a loss, the loss becomes an infinite loss carryforward attribute for the PTE that may be used to offset future tax year income.
ABE owners receive an income tax credit equal to 93.01% of the owner's direct and indirect pro rata share of the tax paid by the ABE. This pro rata allocation is made under a specific Connecticut standard, not by federal income tax principles or any partnership agreement's terms, though those authorities still govern how the deduction for the tax is allocated among owners. The Connecticut standard for allocating the credit is related to the degree that a particular owner contributed to the ABE's tax base. The credit, for individuals and trusts, is refundable, and it appears that the IRS would treat any refund as additional income (see Maines, 144 T.C. 123 (2015)). The credit, for corporate partners, is not refundable but becomes an infinite, nonrefundable carryforward.
Additionally, in determining a credit for taxes paid to other states, each ABE owner who is a full-year or part-year Connecticut resident is entitled to include his or her direct and indirect pro rata share of taxes paid to other states and the District of Columbia, if the commissioner of the Connecticut Department of Revenue Services (DRS) determines the tax is "substantially similar" to the Connecticut ABE tax. As of December 2018, the DRS had not yet identified any taxes as "substantially similar," but it is unclear whether this statement included the Wisconsin PTE tax enacted in December 2018.
Overview of Wisconsin Senate Bill 883
Wisconsin S.B. 883 created an annual election for entities treated as partnerships for federal income tax purposes and for S corporations (i.e., Wisconsin tax-option corporations), permitting these entities to become subject to an optional 7.9% income tax. To make the election for a particular tax year, Wisconsin requires consent by owners holding more than a 50% interest in the PTE. Partnerships will first be able to make the election for tax year 2019. S corporations can make the election for tax year 2018 (but note another state-specific election out of tax-option status that was available in prior years) (Wis. Stat. §71.365(4)(a)).
The base for the Wisconsin PTE tax is established by using the already existing rules for computing PTE income and sourcing it to Wisconsin. An electing entity becomes exempt from nonresident withholding and also receives a unique credit for taxes paid that includes income taxes the PTE pays to other states plus composite tax paid to other states on behalf of Wisconsin resident owners, with a limitation that the other taxes be imposed on the same income taxed under the Wisconsin PTE tax.
PTE owners may exclude their share of PTE activity from their Wisconsin adjusted gross income (AGI), and frequently asked questions documents on the Wisconsin Department of Revenue (DOR) website indicate that a partner or shareholder with no income reportable to Wisconsin would not be required to file an income tax return. If an owner does file — for example, an owner with other sources of Wisconsin income — then the owner would make a tax base adjustment to back out PTE income or loss from the owner's AGI. If an electing entity fails to remit the tax due, the DOR may collect the tax owed by the electing PTE from any owner, in proportion to the owner's share of PTE income.
While the Wisconsin PTE tax remained effective at the time this article was finished, it was part of a legislative act (Act 368) that was the subject of litigation. Specifically, parties are challenging the validity of laws passed during the Wisconsin Legislature's "extraordinary session" in December 2018. Until this litigation reaches a resolution, there may be additional uncertainty for taxpayers considering the election.
Enacted PTE laws: Comparison of selected elements
Mandatory versus optional tax: Because the Connecticut income tax on ABEs is mandatory, each ABE with nexus in the state is subject to the tax, even if the result is detrimental to some or all owners. Negative effects could occur for residents of other states that do not allow consideration of the Connecticut tax in an owner's credit for taxes paid computation and that view the post-credit value as the tax amount paid to Connecticut. For these owners the federal deductibility benefit of the Connecticut tax — even if the Sec. 164(b)(6) state tax deduction limitation is otherwise exceeded — may be less than the additional tax paid to the owner's resident state resulting from the lower credit for taxes paid offset. This same result could occur with the Wisconsin tax plan, but the requirement that owners with more than 50% of the ownership rights approve the election should mitigate the detrimental effect.
Tax rate: The Wisconsin tax is imposed at a rate of 7.9% (i.e., the Wisconsin corporate rate), which is higher than the 7.65% top marginal individual income tax rate, so this tax rate delta is an additional cost to individual owners of electing PTEs. The Connecticut tax is imposed at a rate of 6.99%, which equals the highest marginal individual income tax rate. In Connecticut, individual owners can claim an excess tax credit refund based on any differential between the tax rate imposed on the ABE and the individual's marginal tax rate.
PTE tax base: Connecticut allows ABEs to elect an alternative base that may reduce a potential detriment for ABEs with ownership fully held by entities that are not subject to the Sec. 164(b)(6) limitation. Such an ABE would have a tax base of zero after applying the alternative base ratios, which are computed using individual and trust ownership percentages. There is no equivalent in Wisconsin. Also, an ABE with losses in Connecticut may carry the losses forward, while an electing PTE in Wisconsin is not offered a similar carryforward. In addition, guaranteed payments to a partner would generally be included in the PTE's Wisconsin tax base, but, in Connecticut, an ABE would need to enter into an agreement with the DRS to include guaranteed payments in the tax base. ABEs and owners may favor these agreements if guaranteed payment inclusion results in the owners' avoiding a Connecticut filing obligation.
Nonresident owner filing requirements: A nonresident individual or trust owner is not required to file a return in Connecticut if the owner's only sources of Connecticut income are included in the ABE tax base. Some owners, such as individuals who also had a waived filing obligation in prior tax years based on the composite filing, will view the filing waiver as a benefit. These owners may be willing to forgo any potential refund, such as if the owner is in a tax rate bracket that is lower than the top marginal tax rate bracket. As previously noted, under the Wisconsin PTE tax plan, the owners of electing partnerships and S corporations, who have no other sources of Wisconsin income, are not required to file.
Tiered PTE structures: If an ABE owns an interest in a second PTE, Connecticut requires the ABE to back out the second PTE's activity when determining its Connecticut tax base. If the second PTE was also an ABE subject to Connecticut tax, then any credit related to the tax paid by the second PTE would be available to ABE owners in addition to a credit related to any tax paid by the ABE. In Wisconsin, the rules for tiered partnership structures are less clear; the law provides that the election is intended only to not include the PTE's income in the PTE owner's "Wisconsin adjusted gross income."
Anticipating the IRS's response
It is unclear whether the IRS will respect entity-level taxes enacted as a workaround to the new limitation on state and local tax deductions. Will it matter if a PTE tax is optional versus mandatory? As with Wisconsin's rules, is deductibility affected by the state's ability to collect PTE tax from the PTE's owners? Overall, if it only respects the deductibility of certain PTE taxes, on what criteria would the IRS distinguish between deductible and nondeductible PTE taxes? As these plans are limited to potentially benefit only PTE owners, does that make the government less (or more) likely to issue PTE tax guidance? These are only some of the outstanding questions on the currently enacted PTE taxes and proposals under consideration in a handful of states. While it is still uncertain how Treasury or the IRS will specifically respond to PTE taxes or whether more states will choose to adopt this category of workaround plan, certain states are likely to continue the push for repeal of the Sec. 164(b)(6) limitation.
Mary Van Leuven, J.D., LL.M., is a director, Washington National Tax, at KPMG LLP in Washington, D.C.
For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or firstname.lastname@example.org..
Contributors are members of or associated with KPMG LLP. These articles represent the views of the author(s) only, and do not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.