On January 13, 2020, New Jersey governor Phil Murphy signed into law the Pass-Through Business Alternative Income Tax Act (A-4807/S-3246) (“the act”). This act created an election available to those S corporations, partnerships or limited liability companies (collectively, pass-through entities or PTEs) with nexus in the state to become subject to an entity-level income tax.
Owners of electing PTEs are granted a refundable credit against their New Jersey individual income tax (the gross income tax, or GIT) and/or their corporation business tax (CBT) liability, equal to their share of the electing PTE’s New Jersey entity-level income tax.
The act is intended to annually save between $200 million and $400 million in federal income tax for those owners of electing PTEs who file in New Jersey by “working around” the $10,000 limit placed upon the itemized deduction for state and local taxes (the SALT deduction cap) imposed by Congress’ 2017 tax reform bill (the Tax Cuts and Jobs Act), effectively restoring the full federal deductibility of the related New Jersey income tax.
Entity-level tax mechanics
Effective for tax years beginning on or after January 1, 2020, PTEs may elect to pay an entity-level tax using the following rate schedule, which is based on the sum of each member’s share of distributive proceeds attributable to the PTE:
- 5.675% of the sum of the proceeds not exceeding $250,000
- $14,187.50 plus 6.52% of the sum of the proceeds over $250,000 but not over $1,000,000
- $63,087.50 plus 9.12% of the sum of the proceeds over $1,000,000 but not over $5,000,000
- $427,887.50 plus 10.9% of the sum of the proceeds over $5,000,000
Even though this schedule uses tax rates that are generally higher than those under the state’s gross income tax, the act is intended to be revenue-neutral. This is because the PTE entity-level taxes it produces are creditable against the gross income tax of the PTE’s owners on a refundable basis.
Expanded resident credit for taxes paid to other states
New Jersey also expanded the scope of its historical credit that resident individuals claimed against their New Jersey GIT for income taxes they paid to other states. Under the act, New Jersey residents may now claim credits for other states’ PTE entity-level taxes if the state determines those taxes to be “substantially similar” to the one created by the act.
Based on comments made by the New Jersey Society of CPAs, this change was primarily intended to give New Jersey residents the ability to claim credits for PTE entity-level taxes paid to Connecticut under that state’s own SALT deduction cap workaround law, which is effective for tax years beginning on or after January 1, 2018. Because Connecticut’s PTE entity-level income tax was mandatory rather than elective, New Jersey residents were not previously able to avoid the significant state tax increase created by that Connecticut regime in the form of lost New Jersey credits.
Guidance will be necessary for taxpayers to evaluate which “workaround” laws New Jersey considers to be “substantially similar” to its own. New Jersey is the sixth state to enact such a “workaround” law, following Connecticut, Louisiana, Oklahoma, Wisconsin and Rhode Island.
SALT deduction cap workaround considerations
Even though PTEs that are profitable and have simple structures may be ideal candidates for electing entity-level income taxes under the Act, this New Jersey election may not be beneficial in all cases.
For example, for PTEs whose owners reside in states that do not offer credits for other states’ PTE entity-level income taxes, this New Jersey election might be disadvantageous. In addition, the IRS has not yet issued guidance as to whether “workaround” laws like New Jersey’s will be respected.
We recommend that taxpayers speak to a tax advisor to evaluate whether this election may be right for their unique situation.
The act defines “distributive proceeds” to mean “the net income, dividends, royalties, interest, rents, guaranteed payments, and gains of a pass-through entity, derived from or connected with sources within the State”. Senate Bill 3246, Section 2.
Senate Bill 3246, Section 8, amending N.J. Stat. Sec. 54A:4-1 to contain new subsection (f).