New Jersey Passthrough Tax Counters Federal State Tax Cap

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On January 13, 2020, Governor Phil Murphy signed a new law creating an elective New Jersey business tax regime for pass-through entities (PTEs). The Business Alternative Income Tax (BAIT) applies to S corporations and partnerships as well as LLCs taxed as partnerships. It is available beginning in 2020.

 

New Jersey's BAIT is a workaround for the $10,000 federal cap on state income tax deduction that owners of these entities face after the Tax Cuts and Jobs Act. New Jersey is the sixth state to enact PTE entity-level tax legislation (after Connecticut, Wisconsin, Oklahoma, Louisiana, and Rhode Island). Several others are considering it.

 

Under the bill, electing PTEs pay a tax on their income at the entity level and take a deduction there. The share of income shown on the Schedule K-1 income the PTE owners report is thus already reduced by state tax expense. The owners benefit from the state tax deduction without claiming it as an itemized deduction subject to the cap. To ensure the income is taxed only once, an individual owner takes a credit on his or her New Jersey tax return for the proportionate share of BAIT paid by the PTE.

 

BAIT is paid at a progressive rate based on the amount of income the entity generates, with rates ranging from 5.675% at the lowest levels up to 10.9% when income exceeds $5,000,000. The election must be made by March 15 (for calendar-year PTEs) and the tax is paid by the PTE quarterly.

 

Some Open Issues

Residents pay state tax to their home state on all income wherever earned. They then take a resident credit on their home state return for any tax paid to another state where income is actually generated. It is not clear if other states will allow credit for New Jersey's BAIT since it is paid and deducted by the entity, not by the individual the other state taxes. If non-NJ residents cannot claim their resident credit, they will incur double state taxation on the PTE income and could pay more than if BAIT had not been elected.

 

In New York, a resident credit is not allowed for PTE tax paid by an S corporation. However, the law is silent about PTE tax paid by partnerships and LLCs (probably because these taxes are so new). It is unclear if New York will allow partnership and LLC owners to claim a resident credit for BAIT. If not, the election may not be beneficial for PTEs with New York owners.

 

Another issue is whether PTE owners who live in New Jersey will benefit from all the tax they pay to New Jersey on the PTE's income, or just a portion. The law defines the income subject to BAIT as income derived from New Jersey sources, while residents pay tax on all their income. Due to state allocation factors, all the income of a PTE may not be considered derived from New Jersey.

 

It is also unclear how the IRS will react to the PTE workaround to the state tax deduction limitation. A separate attempt by New York and other states to circumvent the state tax cap using charitable entities was disallowed by the IRS. The IRS has not issued guidance either way on the viability of PTE entity-level tax workarounds such as New Jersey's new BAIT.

 

LM Cohen & Company is following these developing issues and will advise of any updates.All our prior State Tax Alerts, and many topics about the Tax Cuts and Jobs Act, are available on the Updates page of our website.

 

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