The Tax Cuts and Jobs Act of 2017 (TCJA) included an unfavorable 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 change, some states (including Connecticut, Louisiana, Maryland, New Jersey, Oklahoma, Rhode Island and Wisconsin) passed special legislation that allowed businesses to elect to pay state taxes at the entity level, effectively giving rise to a full SALT deduction.
Many S-corporation banks that file tax returns in these states contemplated making this election; however, there was significant uncertainty about whether the Internal Revenue Service would respect this structure, since it was essentially a workaround on the $10,000 SALT cap. Some S-corporation banks elected the entity-level tax, while others played it safe until further guidance was issued.
Fortunately, in recently issued Notice 2020-75, the IRS indicates that proposed regulations 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 definition, it appears that states must have pass-through entity-level taxation for this notice to apply. States that allow a pass-through entity to file composite tax returns or withhold tax payments on behalf of shareholders will not qualify because these tax payments are essentially treated as payments made on behalf of the shareholder (and not by the pass-through entity).
The forthcoming changes mean banks should be contemplating:
- Election to pay state tax at corporate level: If you haven’t explored a state workaround, you should find out if the state(s) you file in provide one and what steps are necessary to make such election. If your state doesn’t today, it may enact similar statutes in upcoming legislative sessions. Also, in the case of banking organizations that have shareholders in multiple states, careful analysis should be performed related to state income tax credits and whether shareholders will continue to receive tax credits for taxes paid to other states at the corporate level.
- Impact on shareholder tax distributions: Most S-corporation banks pay tax distributions to their shareholders on a quarterly basis. If the election above is made, this will reduce the amount otherwise due and payable to the shareholder group. Proactive communication should occur with shareholders regarding this topic. Furthermore, some states require that a majority of shareholders consent to the corporate-level tax. For example, in Wisconsin, the election must be made annually on or before the extended due date of the Wisconsin Form 5S.
- Impact on tax sharing agreements: Most S-corporation banks have tax sharing agreements among the bank, holding company and other related entities. Tax sharing agreements should be reviewed carefully to ensure that tax payments among related companies are handled properly, after factoring in the election to pay state tax at the corporate level.
- Impact on bank regulatory capital: The effect of a corporate-level state tax (for most banks) will be a higher level of regulatory capital in future tax periods (i.e., fewer tax distributions will be needed in comparison with the corporate-level state taxes paid). Regulatory capital levels should be contemplated as part of the bank’s analysis.
- Timing of tax deduction: Some banks use an overall cash basis method of accounting while others use an overall accrual basis method of accounting. Special consideration should be givento 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 objectives of the bank. Furthermore, the timing of the state tax expense may differ for GAAP financial accounting purposes than for tax purposes.
Wipfli’s proactive and specialized tax services can help financial institutions with all their tax needs. To find our more, visit our web page or reach out to your relationship executive.