IRS Announces Approval of SALT Cap Workarounds Using Passthrough Entities

(Parker Tax Publishing November 2020)

The IRS announced that it will issue proposed regulations to clarify that state and local income taxes imposed on, and paid by, a partnership or an S corporation on its income (specified income tax payments) are allowed as a deduction by the partnership or S corporation in computing its non-separately stated taxable income or loss for the tax year of payment and that partners and S shareholders may rely on these rules for payments made after 2017. According to the IRS, specified income tax payments do not constitute an item of deduction that a partner or shareholder takes into account separately under Code Sec. 702 or Code Sec. 1366 in determining the partner's or shareholder's own federal tax liability; rather, such payments are reflected in a partner's or an S corporation shareholder's distributive or pro-rata share of non-separately stated income or loss reported on a Schedule K-1 (or similar form). Notice 2020-75.

Background

Under Code Sec. 164(a), a deduction is allowed for certain taxes for the tax year within which paid or accrued, including (1) state and local, and foreign, real property taxes; (2) state and local personal property taxes; and (3) state and local, and foreign, income, war profits, and excess profits taxes. In addition, Code Sec. 164 allows a deduction for state and local, and foreign, taxes that are paid or accrued within the tax year in carrying on a trade or business or an activity described in Code Sec. 212. Code Sec. 164(b)(2) provides that, for purposes of Code Sec. 164, a state or local tax includes only a tax imposed by a state, a U.S. territory, or a political subdivision of a state or U.S. territory, or by the District of Columbia.

Code Sec. 703(a) generally provides that the taxable income of a partnership is computed in the same manner as in the case of an individual except that the items described in Code Sec. 702(a) must be separately stated and certain enumerated deductions are not allowed to the partnership. For example, Code Sec. 703(a)(2)(B) disallows the deduction for taxes provided in Code Sec. 164(a) with respect to taxes described in Code Sec. 901, which include not only taxes paid or accrued to foreign countries but also taxes paid or accrued to U.S. territories (which are treated as state and local taxes under Code Sec. 164(b)(2)). Code Sec. 1363(b)(1) and (2) generally provide the same with respect to an S corporation.

Code Sec. 702(a) provides that a partner, in determining the partner's income tax, must take into account separately the partner's distributive share of certain partnership items of income, gain, loss, deduction, or credit, (i.e., tax items) as well as the non-separately computed income and loss. For example, Code Sec. 702(a)(6) requires that a partner take into account separately the partner's distributive share of taxes, described in Code Sec. 901, paid or accrued to foreign countries and to U.S. territories.

Code Sec. 1366(a)(1) provides that, in determining the tax of a shareholder of an S corporation, the shareholder is required to take into account separately the shareholder's pro rata share of the S corporation's tax items, the separate treatment of which could affect the liability for tax of any shareholder of the S corporation, as well as the non-separately computed income and loss. For this purpose, Code Sec. 1366(a)(1) requires, in part, that a shareholder take into account separately the shareholder's pro rata share of the S corporation's taxes, described in Code Sec. 901, paid or accrued to foreign countries and to U.S. territories.

In Rev. Rul. 58-25, the IRS ruled that a Cincinnati, Ohio tax imposed upon and paid by a partnership on the net profits of the partnership's business conducted in Cincinnati was deductible in computing the taxable income or loss of the partnership. The ruling holds that "any tax imposed upon and paid by a partnership on the net profits of its business conducted in Cincinnati is deductible in computing the taxable income of the partnership and the partners are not precluded from claiming the standard deduction." Thus, the partners' distributive shares of the net profits tax were not separately stated, and the partners' distributive shares of the partnership's non-separately stated income or loss, which reflects a deduction for the tax paid by the partnership, could be taken into account by the partners in computing adjusted gross income under Code Sec. 62, not as itemized deductions.

Code Sec. 164(b)(6), as added by the Tax Cuts and Jobs Act (TCJA), limits an individual's state and local tax deduction under Code Sec. 164(a) (SALT deduction limitation) to $10,000 ($5,000 in the case of a married individual filing a separate return) for the aggregate amount of the following state and local taxes paid during the calendar year: (1) real property taxes; (2) personal property taxes; (3) income, war profits, and excess profits taxes; and (4) general sales taxes. The SALT deduction limitation applies to tax years beginning after December 31, 2017, and before January 1, 2026, and does not apply to taxes described in Code Sec.164(a)(3) that are imposed by a foreign country or to any taxes described in Code Sec. 164(a)(1) and (2) that are paid and incurred in carrying on a trade or business or an activity described in Code Sec. 212.

With respect to the TCJA SALT deduction limitation, Congress, in H.R. Rep. No. 115-466, provided that "taxes 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 present law."

In Notice 2020-75, the IRS observed that certain jurisdictions have enacted, or are contemplating the enactment of, tax laws that impose either a mandatory or elective entity-level income tax on partnerships and S corporations that do business in the jurisdiction or have income derived from or connected with sources within the jurisdiction. In certain instances, the jurisdiction's tax law provides a corresponding or offsetting, owner-level tax benefit, such as a full or partial credit, deduction, or exclusion. The IRS said it is aware that there is uncertainty as to whether entity-level payments made under these laws to jurisdictions described in Code Sec. 164(b)(2) other than U.S. territories must be taken into account in applying the SALT deduction limitation at the owner level.

Notice 2020-75

In Notice 2020-75, the IRS announced that it intends to issue proposed regulations to provide certainty to individual owners of partnerships and S corporations in calculating their SALT deduction limitations. According to the IRS, based on the statutory and administrative authorities described above, the forthcoming proposed regulations will clarify that "specified income tax payments" (as defined in Notice 2020-75) are deductible by partnerships and S corporations in computing their non-separately stated income or loss.

The term "specified income tax payment" means any amount paid by a partnership or an S corporation to a state, a political subdivision of a state, or the District of Columbia (domestic jurisdiction) to satisfy its liability for income taxes imposed by the domestic jurisdiction on the partnership or the S corporation. This definition does not include income taxes imposed by U.S. territories or their political subdivisions. Thus, this definition solely includes income taxes described in Code Sec. 164(b)(2) for which a deduction by a partnership is not disallowed under Code Sec.703(a)(2)(B), and such income taxes for which a deduction by an S corporation is not disallowed under Code Sec. 1363(b)(2). For this purpose, a specified income tax payment includes any amount paid by a partnership or an S corporation to a domestic jurisdiction pursuant to a direct imposition of income tax by the domestic jurisdiction on the partnership or S corporation, without regard to whether the imposition of, and liability for, the income tax is the result of an election by the entity or whether the partners or shareholders receive a partial or full deduction, exclusion, credit, or other tax benefit that is based on their share of the amount paid by the partnership or S corporation to satisfy its income tax liability under the domestic jurisdiction's tax law and which reduces the partners' or shareholders' own individual income tax liabilities under the domestic jurisdiction's tax law.

Under Notice 2020-75, if a partnership or an S corporation makes a specified income tax payment, the partnership or S corporation is allowed a deduction for the specified income tax payment in computing its taxable income for the tax year in which the payment is made. The notice provides that any specified income tax payment made by a partnership or an S corporation during a tax year does not constitute an item of deduction that a partner or an S corporation shareholder takes into account separately under Code Sec. 702 or Code Sec. 1366 in determining the partner's or S corporation shareholder's own federal income tax liability for the tax year. Instead, specified income tax payments are reflected in a partner's or an S corporation shareholder's distributive or pro-rata share of non-separately stated income or loss reported on a Schedule K-1 (or similar form). Notice 2020-75 provides that any specified income tax payment made by a partnership or an S corporation is not taken into account in applying the SALT deduction limitation to any individual who is a partner in the partnership or a shareholder of the S corporation.

Applicability Date

The proposed regulations described in Notice 2020-75 will apply to specified income tax payments made on or after November 9, 2020. The proposed regulations will also permit taxpayers to apply the rules described in Notice 2020-75 to specified income tax payments made in a tax year of the partnership or S corporation ending after December 31, 2017, and made before November 9, 2020, provided that the specified income tax payment is made to satisfy the liability for income tax imposed on the partnership or S corporation pursuant to a law enacted prior to November 9, 2020. Taxpayers may rely on the provisions of Notice 2020-75 before the issuance of the proposed regulations.

For a discussion of the $10,000 limit on the deduction for state and local income taxes, see Parker Tax ¶83,125.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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