November 26, 2020
I am writing to let you know about a recent development in federal tax law that could have major implications for the residents of California. The 2017 Tax Cuts and Jobs Act (the “TCJA”) severely limited the federal income tax deduction for state and local taxes (SALT). Taxpayers in high taxed states, such as California, have been most affected by this change. In response, several states have restructured their tax systems in an effort to provide some relief to their residents. This month, the Internal Revenue Service (IRS) approved one such state tax regime. See attached and here.
On November 9, 2020, the IRS announced that proposed regulations will clarify that state and local income taxes imposed on and paid by a passthrough entity such as a partnership or an S corporation will be deductible by the entity, and not subject to the SALT deduction limitation that applies to individuals.
Section 164 of the Internal Revenue Code of 1986, as amended (the “Code”) generally allows a deduction for state and local taxes paid. Under the TCJA, individuals who itemize are limited to $10,000 per year of SALT deduction ($5,000 for married individuals filing separately). Generally, passthrough entities do not pay tax at the entity level; instead, the income and loss of the entity is passed through to the owners and the owners are taxed on their pro rata shares of the entity’s income. Under the TCJA, those taxes are not deductible by the owners.
In response to the TCJA, some states have enacted a regime in which a passthrough entity is taxed at the entity level instead of the individual level. In some cases the income is not taxed again at the owner level; in other cases the income is taxed again at the owner level but is subject to a credit for a portion of taxes paid by the entity. In either case, the income is only taxed once and the state income taxes are deductible for federal tax purposes.
Despite the fact that California residents can gain the most from an entity level tax on passthroughs, California does not have such a system. S.B. 539, which would have established a similar structure, was passed by both houses of the California legislature in 2018 but failed to become law. However, now that Notice 2020-75 confirms that an entity level state tax system reduces the federal tax burden on residents of high tax states, I urge you to enact some form of passthrough entity tax, with a corresponding exemption or credit for passthrough owners.
I would be happy to discuss this with you at your convenience.
Very truly yours,
Roger Royse, Attorney at Law