In a welcome notice released on November 9, 2020, the IRS announced that proposed regulations will be issued to clarify that state and local income taxes imposed on and paid by a partnership or an S corporation (i.e., pass-through entities or PTEs) on its income are allowed as a deduction by the pass-through entity in computing its taxable income or loss for the taxable year of payment. As a result, state and local income taxes will be deductible at the entity level and not passed through to individual partners or shareholders of the pass-thru entity who are subject to the $10,000 state and local tax (SALT) deduction limitation that applies to individuals who itemize deductions for federal income tax purposes.
There are seven states which have enacted pass-through entity taxes specifically designed to help circumvent the $10,000 SALT limitation on the individual returns to which the proposed regulations will apply. They are: Wisconsin, Oklahoma, New Jersey, Rhode Island, Connecticut, Louisiana, and Maryland.
The IRS eliminated the first attempted SALT cap workaround in which states proposed allowing state tax credits for donations made to charitable funds. Now that the uncertainty of the IRS’ position regarding this most recent attempted workaround has been removed, additional states are expected to quickly enact some form of a pass-through entity tax.