A proposed bill “Pass-Through Business Alternative Income Tax Act” (S3246) has passed the New Jersey Senate Committee, which would establish a pass-through business entity level tax. A corresponding refundable state gross income tax credit would be allowed. The amended language in the bill would apply the legislation retroactively beginning with 2018 taxable years.
Similar bills have been enacted or have been considered in Connecticut, New York, Oregon, among other states. The new pass-through entity tax would be expected to be fully deductible for U.S. federal income tax purposes, and then offset with a tax credit at the member’s (individual) level. This is an effort by states in their continued response to the state and local tax (SALT) limitation that was introduced as part of the federal tax reform known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97. The TJCA comprised a provision to disallow itemized deductions for state and local taxes of more than $10,000. The anticipated negative effects on owners of New Jersey businesses operating as pass-through entities, have motivated states such as New Jersey in proposing various workarounds.
In most states, pass-through businesses do not pay income tax at the entity level. Instead, the income and losses of pass-through entities are “passed-through” to their owners and taxed as part of the owner’s individual or corporate return. The New Jersey proposed bill allows for the election for entity level tax, with a refundable income tax credit.
The four tax brackets on the entity level tax will range from 5.525% to 10.75%, with the highest bracket kicking in at $3,000,000. The credit will be equal to 89.25% of the owner’s distributive share of the entity level tax, which if the credit exceeds the tax, that excess will generally be refundable.
There are more questions than answers regarding the proposal, as questions continue to linger regarding the recently passed Connecticut entity level tax, as signed by the Governor in May 2018. First, the proposed bill is not clear the ultimate impact to nonresident owners. With the Connecticut legislation, nonresident individuals of an entity are generally not required to file a Connecticut personal income tax return for tax years in which the pass-through is their only source of Connecticut income and the pass-through has paid the entity tax, with certain exceptions including when the individual’s nonresident tax credit is insufficient to fully satisfy the Connecticut personal income tax liability.
In addition, in making this election, pass-through entities will need to consider the potential forfeiture of member’s resident state tax credits in other states, effectively paying tax, both at the entity level, and at the resident level. As the AICPA noted on October 4, 2018 (State Pass-Through Entity-Level Tax Implementation Issues), “…other states will need to determine whether, and how, they will permit their residents to receive credit for the non-resident PTE-level tax imposed on pass-through income in another state. A possible result is different treatment for non-residents in different states, involving the U.S. Constitution…”
Other questions related to the bill include needed clarity on the treatment of tiered business entities, impact on corporate partners, and the general uncertainty if the IRS will challenge these similar entity level taxes, and treat this election similar to the withholding mechanism, impairing the SALT limitation workaround.