The Internal Revenue Service has issued Revenue Procedure (Rev. Proc.) 2019-12, which provides safe harbors under Section 162 of the Internal Revenue Code for payments made by C corporations and certain pass-through entities for which those entities receive or expect to receive a state or local tax credit.
On September 5, 2018, the IRS released an FAQ stating that a business taxpayer making a payment to a charitable or government entity described in Section 170(c) is generally permitted to deduct the payment as an ordinary and necessary business expense under Section 162 if the payment is made with a business purpose. The FAQ also noted that the rules permitting an ordinary and necessary business expense deduction under Section 162 apply to a taxpayer engaged in carrying on a trade or business regardless of the form of the business.
Since the release of the FAQ, questions have arisen, including whether payments by these taxpayers to organizations, described in Section 170, in return for state income, property and other business tax credits would bear a direct relationship to the taxpayer’s trade or business, such that these payments would be considered ordinary and necessary business expenses of carrying on such trade or business under Section 162(a) to the extent of the credit received or expected. The Revenue Procedure responds to these questions.
Rev. Proc. 2019-12 makes it clear that if there is a direct benefit to the pass-through entity in the form of a reduction in state and local taxes that have been imposed on that entity, the payment is to be treated as an ordinary and necessary business expense, fully deductible at the entity level. However, there is language in the Revenue Procedure that creates some concern. The IRS states, “…under the principles of Sections 702 and 1366, the deductibility of the payment must be determined at the level of the individual owners of the entity if the credit received or expected to be received will reduce a state or local income tax subject to the limitations in Section 164(b)(6).” Section 164(b)(6) imposes the $10,000 limitation on state and local income taxes.
The Revenue Procedure goes on to provide examples of safe harbor deductions for pass-through entities. The examples provided include payments in exchange for tax credits offsetting excise tax and property taxes imposed at the entity — not owner — level and make a point to reference that fact. While the Revenue Procedure is not precisely on point with the new Wisconsin law, it does raise concerns as to how the IRS may view payments of income tax, at the entity level, that directly or indirectly relieve the owners of personal income tax liability.
What is unclear at this time is whether the IRS would treat the payment of taxes at the entity level at the higher corporate income tax rate of 7.9% as a tax imposed on the entity rather than its owners. The language of the Revenue Procedure does provide cause for concern.
For individuals owning an interest in a Wisconsin S corporation, immediate consideration should be given to whether to pay fourth-quarter individual Wisconsin estimates in the event the entity decides not to make the election to pay Wisconsin taxes at the entity level. For clients with sufficient cash flow, the conservative approach will be to make those fourth-quarter payments in the event a Wisconsin election is not made.
On March 15, 2019, S corporations will need to fund the payment of entity-level taxes with the extension of the return if an election to pay the state tax at the entity level is anticipated. The filing of these extended returns is likely to occur in late July or early August when Wisconsin finalizes its forms. Wisconsin has already indicated that it will not transfer nonresident withholding payments made previously to fund the payment of entity-level tax. On April 15, absent any guidance from the IRS, decisions will need to be made about whether to include the S-corporation income in the computation of Wisconsin income for extension purposes.
We will continue to monitor developments at the federal level as they relate to the deductibility of state taxes at the entity level.