Many New Jersey residents who had previously taken itemized deductions on their Federal income tax returns discovered last year that it was pointless to do so, again, because of the State and Local Tax (“SALT”) limitations that were included in the Tax Cuts and Jobs Act of 2017 (“TCJA”). The TCJA rules impose a $10,000 cap ($5,000 for married filing separately) on the deduction of the sum of the following state and local taxes paid during the calendar year: (1) state and local real and personal property taxes; (2) state income taxes; and (3) general sales taxes.[i] As described by the IRS in Revenue Ruling 2019-11: “The dollar limitations apply to taxable years beginning after December 31, 2017, and before January 1, 2026, but they do not apply to foreign taxes described in section 164(a)(3) or to any taxes described in section 164(a)(1) and (2) that are paid or accrued in carrying on a trade or business or an activity described in section 212.”[ii] In other words, it is still permissible to deduct these expenses in computing taxable income for a business or rental property, but not when itemizing deductions on Schedule A of your personal Federal income tax return (Form 1040). As a result, many persons, who formerly itemized their deductions, have now been forced to take the standard deduction. As it turned out, that was, in many instances, a better option due to the overall reduction in tax rates coupled with several new tax credits. However, the optics are terrible for states like New Jersey, California, and New York, whose residents pay disproportionately higher income and property taxes than their counterparts in many other parts of the country.
As a result, not only have there been lawsuits initiated by these high-tax states seeking to nullify the TCJA’s SALT limitations but many of the states, including New Jersey, have passed “workaround” legislation in an attempt to preserve the full deduction of SALT taxes paid by their residents. One such approach, implemented by New Jersey, was to allow its residents to make a charitable contribution to a state or local government fund and receive both a state tax credit for up to 90% of the contribution made AND a Federal charitable contribution deduction, which was not impacted by TCJA. [iii] This seemed like a good workaround, but the IRS was not impressed. They have since passed new regulations that limit the ability of individuals to effectively convert a state property tax payment into a charitable contribution.[iv] The regulations became effective on August 11, 2018, for contributions made after August 27, 2018 and dramatically curtail New Jersey residents from getting around the SALT limits.
Basically, the regulations attempt to clarify a long-standing doctrine in the tax code, which limits the deduction of any charitable contribution where the taxpayer receives some benefit for having made the contribution. For example, if a taxpayer makes a $10,000 contribution to their local church, which includes the cost of education for the taxpayer’s child (value of $3,000), the rules require that the taxpayer reduce their charitable deduction by the $3,000 value of their child’s private education. When the smoke clears, the taxpayer’s deduction for charitable contributions would be limited to $7,000 ($10,000 - $3,000). Similarly, when New Jersey provides a tax credit based on a contribution made to a state charitable fund, the net cost to the donor is less than the original amount. Accordingly, under the new regulations, the donor’s charitable contribution deduction would be reduced for the amount of the credit received.
Not to be discouraged, New Jersey has designed yet another workaround for the SALT limitation for those with pass-through business entities (PTEs). Proponents of this new workaround argue that the SALT limitation unfairly discriminates against PTEs (S Corporations, LLCs, and Partnerships) by causing them to be subject to the $10,000 SALT limit while C Corporations are otherwise exempt. The reason this inequity exists is because owners of PTEs do not take a deduction for state income tax related to the net profits of their business on their entity’s tax return – the tax on the business profit is calculated on the owner’s personal tax return, unlike a corporate entity which receives the full benefit of state tax paid on the entity’s tax return. For the PTE, a deduction for any part of the state tax paid over the SALT cap is lost when computing an owner’s itemized deductions on their personal federal tax return. For example, assume Red LLC has two equal owners, and they report $200,000 net profit on their partnership return (Form 1065). Each owner would receive a K-1 from the partnership and recognize $100,000 of net profit on their state AND federal tax returns. If they each paid $10,000 in real estate taxes on their personal residence and $4,000 of state income tax on the business profit, they would only be permitted to deduct $10,000 of the $14,000 paid as an itemized deduction under the SALT limitation.
On January 13, 2020, New Jersey enacted the “Pass-Through Business Alternative Income Tax Act” (BAIT),[v] where pass-through entities (“PTEs”) may make an election to pay state income taxes on their entity tax return. Owners would receive a corresponding credit on their NJ personal return for the tax on the remaining net flow-through earnings. When the dust settles, the owners have paid no additional state income tax, yet have preserved a full deduction for federal purposes since the distributive share from the entity reportable on the owner’s federal return (1040) has been reduced by the BAIT tax.
The new elective BAIT tax is effective for tax years beginning after 12/31/19 and is not available to single-member LLCs and sole-proprietorships. Whether the IRS will undertake steps to curtail the benefits of the BAIT tax, remain to be seen. However, the new law provides an excellent planning opportunity for owners of flow-through business entities in 2020.
[i] Section 164(b)(6), as added by section 11042 of the “Tax Cuts and Jobs Act”, Pub. L. 115-97.
[ii] IRS Rev. Rul. 2019-11, 3/29/19
[iii] 2018 Bill Text NJ S.B. 1893
[iv] Treasury Regulations, T.D. 9864, 84 FR 27513, effective August 12, 2019.
[v] P.L. 2019, c.320 (S3246/A4807).
The tax professionals at Reger Rizzo & Darnall are available to discuss the nuances and exceptions in the recent regulations and help business owners maximize their tax-saving opportunities in the New Year. For questions, comments or additional information, please contact Rick Marmon at 856.900.6824 or via email at firstname.lastname@example.org, or Ernie Ehling at 856.900.6822 or via email at email@example.com.