Many states offer new elective tax regimes for pass-through entities (PTEs) that shift the incidence of taxation from the owner level to the entity level. The aim of these “workaround” regimes is to bypass the $10,000 state and local tax (SALT) deduction limitation imposed on individuals by Internal Revenue Code (IRC) Section 164(b)(6). The IRS blessed these techniques over a year ago in Notice 2020-75, but only for specified income tax payments (SITPs) that are paid. A cash basis PTE must pay SITPs by the end of the tax year. But with careful planning, there is substantial authority for accrual basis PTEs to apply Notice 2020-75 to SITPs that are either paid or accrued. For many PTEs, time is of the essence for this strategy because it depends on resolutions that must be in force by the end of the tax year.
PTEs (e.g., partnerships and S corporations) are allowed deductions for state and local income taxes directly connected with their trade or business for the taxable year within which they are paid or accrued, and do not need to separately state them. However, PTEs are not allowed SALT deductions for mere payment obligations with respect to taxes actually imposed on the PTE owners (e.g., PTEs cannot deduct payments that are required to be made on behalf of their owners for “nonresident withholding,” “composite income tax filing,” or similar arrangements. But state taxes directly imposed on PTEs are deductible by PTEs in calculating non-separately stated ordinary income or loss – a conclusion that pre-dated and was unchanged by the 2017 tax reform law commonly known as the Tax Cuts and Jobs Act.
New Elective State Tax Regimes
Historically, PTE owners have been subject to the $10,000 SALT deduction cap on taxes related to pass-through income, because these owners must claim such taxes as itemized deductions.
States are now rolling out new regimes that impose either a mandatory or elective entity-level income tax on PTEs. The intended result of these new regimes is to shift the incidence of tax from the owner level to the entity level, so that the state tax is now directly imposed on the PTE. Section 3.02 of Notice 2020-75 favorably confirms that SITPs made pursuant to the direct imposition of income tax on PTEs are deductible by PTEs in calculating non-separately stated ordinary income or loss, regardless of whether such entity-level taxes are the result of an election. PTEs should consider several other factors aside from the effect on the $10,000 SALT deduction cap before making an election into these new regimes, as we profiled in a previous article.
Despite its favorable position, the IRS also states in section 3.02(1) of Notice 2020-75 that an SITP “means any amount paid by a partnership or an S corporation to satisfy its liability for income taxes imposed by the Domestic Jurisdiction on the partnership or S corporation” [emphasis added]. The IRS definition does not include the phrase “or accrued,” leaving many to wonder whether accrued state taxes can otherwise be treated as SITPs for purposes of Notice 2020-75.
The IRS references the phrase “paid or accrued” several times throughout section 2.01 of Notice 2020-75, in describing the authorities upon which Notice 2020-75 is based. Section 3.01 of Notice 2020-75 then specifies that SITPs (later defined in section 3.02) are deductible “[b]ased on the statutory and administrative authorities described in section 2.” Because the omission of the phrase “or accrued” from the SITP definition in section 3.02 does not reconcile with the IRS summary in section 2 and Section 164, and because the IRS indicated that it did not intend to change present law under Section 164 (which would include the legislative history referenced in section 2), we believe there is substantial authority to incorporate the phrase “paid or accrued” in the SITP definition throughout Notice 2020-75.
Despite moving past that obstacle, there is another hurdle that potentially impedes a tax deduction for accrued entity-level taxes. Because the PTE will typically make the election into the new state tax regime by including the appropriate statement with a timely-filed return, PTEs will not make these elections until after the end of the tax year. This means that the fact of the PTE’s SITP accrued liability is not fixed by the end of the tax year, which is problematic under the all events test. Perhaps the IRS assumed this result in failing to reference “accrued” in defining SITPs in Notice 2020-75. In any event, all hope is not lost.
All Events Test for Elective SITPs
Taxpayers using an accrual method of accounting generally may not deduct items of expense prior to the time when all events have occurred that fix the obligation to pay the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred. Economic performance generally occurs for tax liabilities as the tax is paid to the governmental authority. Taxpayers that adopted the recurring item exception as a method of accounting for taxes are permitted to take a liability to pay taxes into account in the taxable year before the taxable year during which economic performance (e.g., payment) occurs.
Notwithstanding the recurring item exception, there is the threshold question about whether the fact of the liability is fixed by the end of the year. For instance, if the entity-level tax election for a PTE is not made by the end of the year, the fact of the liability to pay entity-level taxes to a particular jurisdiction is not fixed by the end of the year. Careful and timely planning can remediate that deficiency, however.
In situations where there is no legal liability at the end of the tax year, the fact of a liability nevertheless exists when the taxpayer obligates itself, through board action, to incur the liability by the end of the tax year. There are multiple authorities that found a fixed liability to exist upon the execution of a board resolution by the end of the tax year that creates a binding and enforceable obligation on the company under the relevant state law. In this case, the board’s action must also specify that it forfeits any right to subsequently modify or eliminate the present decision to compel the company to incur the obligation. Furthermore, in order to be certain that the board’s action is legally binding and enforceable, the board must have the authority and capacity to make the action. For instance, the action must not be subject to committee approval or any other concurrence review by another party.
Assuming that a board resolution is properly structured under these tenets, we believe there is substantial authority to treat the board’s action as creating an obligation that fixes the fact of the actual liability by the end of the tax year.
For examples of the myriad ways the IRS may attack attempts to fix a liability by year end, refer to our previous articles on deductibility of employee bonuses.
Please note that “substantial authority” is not a guarantee that your position will be sustained upon audit, but it allows you to take the position on your tax return without further disclosure to the IRS, and guards against penalties if ultimately the IRS is successful upon audit.
Finally, your tax preparer cannot draft Board resolutions or give you examples, because that could be the unauthorized practice of law and each state may have different rules. As a result, your attorneys must draft the necessary Board resolutions. If your attorneys would like CBIZ to review the resolutions, we can comment on them; however, the ultimate responsibility for the resolution must rest with the attorneys.
To recap, we believe there is substantial authority for the following positions:
- PTEs may incorporate the phrase “paid or accrued” in the SITP definition throughout Notice 2020-75;
- PTEs with a board resolution structured under the following tenets may treat the board’s action as creating an obligation that fixes the fact of an elective entity-level state income tax liability
- The board resolution must compel the PTE to make the appropriate election(s) for entity-level state income taxation with each specified jurisdiction (i.e., the resolution cannot merely authorize the PTE to make the appropriate election(s));
- The board must have the authority and capacity to make the action, and the action must not be subject to committee approval or any other concurrence review by another party;
- The board must specify in its resolution that it forfeits any right to subsequently modify or eliminate its resolution to compel the company to make the appropriate election(s) for entity-level state income taxation with each specified jurisdiction; and
- The board resolution must be properly executed and recorded by the end of the tax year.
Time is of the essence for PTE boards to take action, which must be made effective by the end of the tax year. And remember that ultimate deductibility is also dependent on use of the recurring item exception by the PTE under its present method of accounting. Affected PTEs should discuss action with their attorneys as soon as possible.
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