Some tax planning strategies sound too good to be true. That is especially the case when the tax savings are permanent in nature or are of a sizeable amount — or both.
When the IRS blesses such a tax planning strategy, taxpayers should pay close attention. That is exactly what happened with SALT workarounds for pass-through entities, including S-corporation banks. More states are enacting SALT workarounds that align with the IRS guidance, resulting in permanent and sizeable tax savings for S-corporation banks.
If you are in one of these states, you should capitalize on this opportunity.
By way of background, the Tax Cuts and Jobs Act of 2017 (TCJA) placed a cap on the ability to deduct state and local taxes (SALT) as an itemized deduction on Schedule A. The cap was set at $10,000 (or $5,000 in the case of married individuals filing a separate tax return), effectively causing most S-corporation shareholders’ SALT deductions to be limited.
In response to this unfavorable tax law change, some states passed special legislation that allowed businesses to pay state taxes at the corporate level, effectively giving rise to a full SALT deduction. This sounded too good to be true; however, the IRS issued favorable guidance in Notice 2020-75 that addressed this tax planning strategy.
In Notice 2020-75, the IRS indicated that proposed regulations are forthcoming and will clarify that SALT imposed on and paid by an S corporation on its income will be allowed as a tax deduction in computing non-separately stated taxable income or loss for the taxable year of payment.
Specifically, the notice indicates that a specified income tax payment is tax deductible. This is defined as “any amount paid by a partnership or S corporation to a state, a political subdivision of a state, or the District of Columbia (Domestic Jurisdiction) to satisfy its liability for income taxes imposed by the Domestic Jurisdiction on the partnership or the S corporation.”
Based on this favorable guidance, many states are now enacting new pass-through entity-level taxation that aligns with the requirements of the IRS notice. Presently, the states with SALT workarounds include the following — and this list continues to expand:
- New Jersey
- New York
- Rhode Island
- South Carolina
Some of the items to contemplate — with assistance from your tax advisor — include the following:
- Election to pay state tax at the corporate level. Each state has its own process for implementing the SALT workaround; thus, it is very important to understand each state’s specific requirements to ensure the tax planning strategy is properly executed. In the case of banks that have shareholders in multiple states, careful analysis of state income tax credits and whether shareholders will receive tax credits for taxes paid to other states at the corporate level should also be performed.
- Impact on estimated tax payments and shareholder tax distributions. Most S-corporation banks pay tax distributions to their shareholders on a quarterly basis. If the election is made to pay state tax at the corporate level, this will reduce the tax distribution otherwise due and payable to the shareholder group. Proactive communication with shareholders regarding this topic should occur. In addition, estimated tax payments will generally need to be made at the corporate level to avoid underpayment interest and penalties.
- Impact on tax sharing agreements. Most S-corporation banks have tax sharing agreements among the bank, its holding company and other related entities. If an election is made to pay state tax at the corporate level, tax sharing agreements should be reviewed carefully to ensure tax payments between related companies are handled properly. For example, a holding company tax loss would generally require an intercompany state tax benefit payment.
- Impact on regulatory capital. Generally speaking, the election to pay state tax at the corporate level should result in a higher level of regulatory capital over time. That is because lower tax distributions will be needed in comparison with the additional corporate-level state taxes paid. Regulatory capital levels should be contemplated as part of the bank’s analysis.
- Timing of tax deduction. The timing of state tax deductions — and the recording of state tax expense — may differ for GAAP financial accounting purposes and for tax purposes. For tax purposes, many S-corporation banks have elected an overall cash basis method of accounting, while others utilize an accrual basis method of accounting. Special consideration needs to be given to the overall accounting method utilized by the bank, especially as it pertains to the timing of the corporate-level tax election and when estimated tax payments are actually paid to the state taxing jurisdiction. Careful tax planning may be necessary to ensure the timing of the tax deduction aligns with the bank’s objectives.
How Wipfli can help
Our dedicated state tax professionals can help implement and manage solutions to mitigate exposure, avoid paying too much tax, and create a competitive advantage. Learn more on our state and local tax services web page.