Current tax law limits State and Local Tax Deductions to $10,000. This law applies to individuals whom itemize deductions on Schedule A. This has been a thorn in the side of those who live in high-tax states, such as California, where things are only set to get worse from a taxation standpoint. There is, however, finally some good news for those who have a passthrough entity, such as an S-Corporation or Partnership. On November 9th, the IRS released Notice 2020-75 which stated their intention to allow for the deduction of State and Local Taxes paid for by a pass-through entity to bypass the $10K limitation.
How exactly does this work?
- The passthrough entity pays State and Local Taxes on behalf of a shareholder/member.
- The shareholder/member receives a State tax credit for this payment on their individual tax return.
- The entity takes the State and Local Tax Deduction on its’ return which reduces the Federal taxable income that flows through to the shareholder/member. This allows for circumventing reporting the taxes on shareholder/member’s Schedule A.
In order for this to work, the state in question must have an entity-level tax on passthrough-entities. These states, as part of this tax, have provided for the state tax credit mentioned above. Currently, only Connecticut, Louisiana, New Jersey, Oklahoma, Rhode Island, and Wisconsin have enacted an entity-level tax. It is very likely, however, that other states will follow suit once the regulations are indeed promulgated.
What’s more is that the Notice stated that this favorable tax treatment will be allowed whether or not the state entity-level tax is mandatory or elective.
If you’re wondering whether you can just create an entity to funnel your State and Local Taxes through to achieve this workaround, you shouldn’t count on it. The IRS is likely to become wise to schemes like this and will clarify that the business operations of the entity in question would need to have economic substance. Further, they are likely to require that the participation of the shareholder/member be active, as opposed to passive.
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