Let’s say that a New Jersey taxpayer is self-employed, with a net taxable income reported on Schedule C of Form 1040 of $225,000. This person was referred to you because you are a CPA who provides value-added tax planning opportunities, and the current accountant only provides compliance work. Eager to impress and provide tax savings, you suggest that the taxpayer makes a New Jersey Business Alternative Income Tax (BAIT) election.
This seems like a no brainer at first, because the BAIT was put in place by New Jersey to help those taxpayers impacted by the federal $10,000 state and local tax (SALT) deduction limitation. However, before adopting BAIT, an analysis should be provided so the taxpayer can make an informed decision.
By the Numbers
In this example, by reviewing the 2021 tax return, the federal tax rate was 27 percent and the income is expected to be same as last year — or “SALY” for the accounting nerds. Their $225,000 income multiplied by the New Jersey tax rate of 5.68 percent and by the federal tax rate of 27 percent provides a tax savings of $3,450.
The taxpayer is happy, but is that really the savings to the client?
As a CPA, include the following additional costs for year one of this tax strategy:
- Applying for a federal Employer Identification Number (EIN) and forming a taxpayer and spouse LLC in New Jersey: $750
- NJ LLC initial filing fee: $125
- Fee for making the BAIT election: $250
- Preparation fee for the LLC and BAIT tax returns: $1,000
If the taxpayers chose to engage an attorney to draft an operating agreement, this would represent an additional fee. In this case, since the members are married, they decided to pass on an agreement.
This leads to estimated tax savings after additional costs in year one of $1,325.
In year two and going forward, estimated tax savings would be $2,450.
Presenting this sort of breakdown to a client provides a more accurate description of the potential net savings when considering the BAIT election. Based on the facts and circumstances, it could make sense to elect S corporation status and then include the fee for adding the taxpayer to payroll. This includes the filing of federal and state quarterly payroll reports, year-end reports and obtaining workers’ compensation insurance, all of which needs to be factored into the net savings to the taxpayer. If the decision to elect S corporation status is made after the due date (75 days from the beginning of the year), there is relief available at both the federal and New Jersey levels. Then, subtract $100 from the savings analysis for the retroactive, late New Jersey S-election.
Taxpayers who already have an existing partnership or S corporation do not need this analysis since most of these costs either do not apply to them or have been already accounted for.
BAIT Rules Recap
A single-member LLC and a sole proprietorship may not elect to pay the BAIT, as only a pass-through entity, such as an S corporation or a multi-member partnership, are permitted to do so.
As a workaround to the $10,000 SALT deduction cap for individuals that included in the Tax Cuts and Jobs Act (TCJA), many states, including New Jersey, enacted pass-through entity (PTE) taxes as an elective tax. The IRS issued Notice 2020-75, which clarified that partnerships and S corporations may deduct their SALT payments at the federal entity level when computing taxable income or loss.
There are some other considerations to keep in mind:
- New Jersey requires the BAIT election to be made annually. If the election is made, but later determined that the election should be revoked, file the revocation and claim for refund form, and the entity will receive any estimated tax payments made.
- Quarterly estimated tax payments are needed. Otherwise, underpayment penalties can be assessed.
- BAIT payments reduce the Sec. 199A qualified business income deduction as well as the amount that can be contributed to a SEP-IRA and other retirement plan options. Consider a solo 401(k) over the SEP-IRA since New Jersey permits a deduction for the 401(k) but not the SEP-IRA.
Ultimately, the tax savings are the most important factor when deciding whether electing BAIT makes sense, but they are not the only factor, as there are other costs. The higher the taxable income, the easier this decision becomes. What is the income amount needed? As with determining the reasonable compensation for an S corporation owner, it depends. The CPA plays a vital role in answering those questions.