Will You Take the “BAIT?”
A national trend ensuing the Tax Cuts and Jobs Act (TCJA) has been states’ attempts to circumvent the $10,000 state and local tax (SALT) deduction limitation. New Jersey is one of the latest states to enact such a SALT workaround, using an entity-level tax known as the Pass-Through Business Alternative Income Tax (BAIT).
The SALT limitation has profoundly impacted mid-market businesses. As these businesses predominantly use “pass-through” entities (PTE) in structuring their affairs, businesses were awarded with cuts to their marginal tax rates, but in many cases these tax cuts were nullified by the inability to continue to deduct SALT.
Pass-through businesses are generally not subject to an entity-level tax. Conversely, the profits flow through to the owners and, as such, are taxed under the individual income tax regime. In high-taxed states, many owners of pass-through businesses, such as partnerships, limited liability companies and S corporations, found themselves with an increased tax burden, or, at best, a reduced net benefit.
It’s been repeatedly reported in the news that the TCJA SALT limitation brought for the first time in over 100 years the inability for taxpayers to deduct SALT. As such, this results in taxes on income that in effect are being double taxed at the federal and state levels. States previously operated under the long-standing precedent that the federal code provides for deductibility. Some states, including New Jersey, contribute significantly more taxes to the federal government than they receive back in federal spending, according to “Giving or Getting,” a January 2020 report from the Rockefeller Institute of Government. Also, statutory deductions and credits are not adjusted in states with higher costs of living. The pre-TCJA SALT deduction counterbalanced some of these inequities.
As a result, many states have been scurrying around in conjunction with research policy institutes attempting to devise legislation to overcome the impact of the TCJA to its constituents. Most notably, a number of states have enacted legislation using PTEs in an attempt to mitigate the SALT limitation impact. The entity-level tax at the PTE attempts to sidestep the SALT limitation by shifting state taxes from the individual to the PTE, allowing the owners to claim a credit on their state tax return for the owner’s distributive share of taxes paid by the PTE. To date, a number of states have enacted PTE SALT workarounds. New Jersey’s PTE workaround has received a lot of attention as it is one of the highest-taxed states in the nation.
Enticing Businesses with New Jersey “BAIT”
The pass-through income tax, or BAIT, applies to tax years beginning on Jan. 1, 2020, and provides PTEs the opportunity to alleviate the effects of the SALT limitation. The annual election allows PTEs to elect to pay tax due on the owner’s share of distributive proceeds at the entity level; the owners may then claim a tax credit for the amount of tax paid by the pass-through entity. The annual election should be made electronically on or before the original due date of the entity’s return. Distributive proceeds means income sourced to New Jersey under the Gross Income Tax. As the BAIT sources its income based on the rules of the Gross Income Tax Act, the election of the BAIT may result in the application of “cost of performance” sourcing for S corporations as opposed to market sourcing which S corporations are subject to.
Conceptually speaking, by passing through a net amount of income reduced by the SALT deduction, the owner is able to fully deduct their New Jersey taxes for federal purposes. Looking at this in a vacuum, the savings are unmistakable. For simplicity, on $5 million of distributive proceeds, that’s about $427,888 in New Jersey BAIT tax. Assuming all things equal, and with a federal top marginal rate of 37 percent, that’s about $158,000 in savings!
Will You Take the “BAIT?”
Despite these potential savings, some New Jersey businesses remain reluctant to take the BAIT. First, there has been the concern about possible IRS challenges. The IRS did block the charitable deduction SALT workarounds. IRC 164(a) allows for businesses to deduct state income taxes. The TCJA Conference Report issued by Congress affirmed that taxes imposed at the entity level, such as a business tax imposed on pass-through entities, would continue to be deductible without limitation. With this said, on Nov. 9, 2020, the IRS issued Notice 2020-75 explaining that it intends to issue proposed regulations supporting the use of PTE SALT workarounds. The notice affirms that the proposed regulations would not make a distinction between a PTE tax which may be mandatory (e.g., Connecticut) versus a PTE tax made by election, such as the New Jersey BAIT. As some businesses had been in a wait-and-see position, this taxpayer-friendly announcement will help alleviate some concerns.
A remaining concern with the BAIT is whether non-resident owners would be permitted to receive credits in their resident states for PTE entity-level tax imposed in New Jersey. Although a handful of states have provided general guidance, states such as New York and others have not provided explicit direction and could subject owners to double taxation. Like the original IRS concern, the electability feature of the tax versus a mandatory imposition may be relevant with resident credits. Possible planning to overcome this might include reorganizing the business into a multi-tiered structure, with the owners split at the upper tier based on their state residency; the BAIT would only be elected by the entity comprised of New Jersey residents.
Businesses should be mindful that the BAIT will be most helpful to businesses with significant New Jersey presence, as it is computed based on income derived from New Jersey. Undoubtedly the BAIT election could be a compelling and effective tax planning strategy, but businesses need to holistically review their affairs before biting at the BAIT.
Disclosure: This article was written in November 2020 when the magazine issue went to press; therefore, some of the information and views presented may be outdated.
Jason Rosenberg, CPA, CGMA, EA, MST, is a senior manager in the State and Local Tax Practice at Withum. He is a member of the NJCPA Content Advisory Board.
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This article appeared in the January/February 2021 issue of New Jersey CPA magazine. Read the full issue.