The IRS's clarification in 2020 that partnerships and S corporations may deduct their state and local tax (SALT) payments at the entity level in computing their nonseparately stated taxable income or loss was welcomed by taxpayers and their advisers.
After all, partners or shareholders might otherwise have to reckon with the Sec. 164(b)(6) $10,000 SALT deduction limitation (SALT cap) enacted by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-57, on their distributive or pro rata shares of the deduction.
Practitioners should be mindful of the timing of state and local passthrough-entity (PTE) tax payments giving rise to the deduction, especially now, in the approaching year's end, so that PTEs and their partners or shareholders may make optimal use of the provision, AICPA tax policy advocates say. But they add that practitioners should also be aware of uncertainty surrounding whether a payment is of a legally binding tax liability if the PTE's election to pay an optional SALT can only be made on the 2021 return filed in 2022.
The IRS issued Notice 2020-75 in November 2020, saying it intended to issue proposed regulations to clarify that "specified income tax payments" imposed on and paid by PTEs are included in nonseparately stated taxable income or loss for the year of payment. Previously, taxpayers and others had questioned whether SALT payments reflected in partners' or shareholders' distributive or pro rata share of income or loss were subject to the SALT cap.
Specified income tax payments are limited to tax payments by a PTE to a state, a political subdivision of a state, or the District of Columbia to satisfy the PTE's income tax liability imposed by the jurisdiction. Specified income tax payments made by a PTE are not taken into account in determining the SALT deduction under the SALT cap of any individual who is a partner or shareholder of the PTE.
Crucially, a specified income tax payment is one the PTE "makes ... during a taxable year" in computing its taxable income "for the taxable year in which the payment is made" (Notice 2020-75, Section 3.02(2)). Even though Sec. 164(a) provides that the SALT deduction is for the tax year in which taxes are "paid or accrued," the more restrictive, literal application of the notice to taxes paid is the safer course, advocates say.
"The plain language of the notice strongly suggests that a PTE tax must be 'paid,'" said Alexander Scott, J.D., LL.M., a senior manager with AICPA Tax Policy and Advocacy in Washington, D.C. "The prudent course does appear to be to properly elect, if applicable, and pay by Dec. 31, 2021, depending on the state PTE regime, in order to benefit from the SALT cap deduction in 2021."
"Many firms are advising clients to pay the tax by year end to be on the safe side and comply with the 'four corners' of the notice," Scott said.
Accordingly, taxpayers and their advisers may wish to make sure they pay SALT in 2021 if they expect the notice to apply for the year, and this may be true of SALT liabilities with respect to the 2021 tax year that might otherwise be paid with a return filed in calendar 2022.
As the notice also stated, even over a year ago, many state and local jurisdictions had enacted or were planning to enact new PTE income taxes, some with a corresponding or offsetting credit, deduction, or exclusion. The notice also clarified that entity-level payments under these laws are not precluded from nonseparately stated treatment.
State PTE taxes, like other income taxes, generally provide for estimated taxes to be paid during the tax year, but because of the COVID-19 pandemic or natural disasters, some estimated tax requirements may have been suspended for 2021. New York made 2021 estimated taxes optional for PTEs, but electing PTEs may choose to make any estimated tax payment before Dec. 31, 2021 (N.Y. Technical Memorandum No. TSB-M-21(1)(C)).
In some states, such as New York, the PTE tax itself may be elective. For tax years beginning on or after Jan. 1, 2021, nonpublicly traded partnerships with New York–source income can elect to be taxed at the partnership level (N.Y. Tax Law Article 24-A). That election was required to have been made by Oct. 15, 2021, for the 2021 tax year, according to the TSB, but other states may have later or less restrictive elections.
However, some states, such as California, require an election to pay PTE tax to be made on a timely filed return, which generally wouldn't happen for 2021 until calendar 2022.
In that case, a 2021 payment may be considered a "deposit" with no legally binding tax liability for it until the 2021 return is filed making the election, pointed out Annette Nellen, Esq., CPA, CGMA, a professor at San José State University and a past chair of the AICPA Tax Executive Committee.
"The rules differ among all states," Nellen said. Thus, she said, it is important for advisers to "run the numbers" to understand the effect on the entity and owners of a state tax credit generated by a payment. Issues to be assessed include whether the credit generated can be fully used in the current year, whether the state allows a carryover, and whether the credit applies against state alternative minimum tax, where applicable.
— To comment on this article or to suggest an idea for another article, contact Paul Bonner at Paul.Bonner@aicpa-cima.com.