The new law allows pass-through entities such as S corporations and LLCs to elect to pay NJ income tax at the entity level, as a business tax, and to pass through a net amount of Federal taxable income to the owners of the business along with a gross amount of NJ taxable income a NJ tax credit to prevent double taxation in NJ. By passing through a gross amount of NJ taxable income and a credit, the owner is not required to separately pay NJ income tax that could be subject to the SALT limit. Absent this election, the business would pass through a gross amount of Federal and NJ taxable income to the owner, the owner would pay NJ income tax, and the owner’s tax payment would be subject to the SALT limit.
Consider the following simplified example. S corporation (S) has net income of $1,000,000 in 2020, and one individual shareholder (A). Absent the election, S would pass through to A $1,000,000 of net income and A would pay NJ income tax of approximately $60,000. Most of this payment, or $50,000, would not be deductible at the Federal level because of the SALT limit. Alternatively, if S elects to pay tax at the entity level, it would pay approximately $60,000 in NJ income tax and pass through to A $940,000 of net Federal taxable income and $1,000,000 of NJ taxable income and a $60,000 NJ tax credit. A would then file tax returns showing $940,000 for Federal tax purposes, and $1,000,000 for NJ tax purposes, but no additional NJ tax payment would be due because of the $60,000 tax credit. In this scenario, the election effectively allows A to avoid the SALT limit and to deduct at the Federal level the full $60,000 NJ tax payment, resulting in tax savings from the base case where the deduction was limited to $10,000.
Business owners should keep in mind that the election to pay tax at the entity-level is subject to certain restrictions and requirements. The treatment of the election for Federal income tax purposes is uncertain, and likely to be challenged by the IRS. In addition, non-NJ resident partners of an entity that elects to pay the NJ entity-level tax may not receive a credit in their home states for the NJ tax paid, resulting in double state income taxation. Prior to making the election, business owners should discuss the options with their tax advisor to determine if the election would be appropriate in their particular circumstances.