New Jersey enacts SALT deduction cap workaround

On Jan. 13, 2020, New Jersey Gov. Phil Murphy signed legislation creating the Business Alternative Income Tax (BAIT), an elective entity-level tax on pass-through businesses for tax years beginning on or after Jan. 1, 2020.¹ Effective immediately, the legislation allows New Jersey pass-through entities (PTEs) to pay tax at the entity level and permits owners of the PTE to obtain a corresponding tax credit against their personal income tax liability in an effort to circumvent the $10,000 state and local tax (SALT) deduction limitation implemented by the Tax Cuts and Jobs Act of 2017 (TCJA).² Corporate members are also given a credit against New Jersey Corporation Business Tax (CBT) liability. The legislation establishes four tiers of tax rates depending on the distributive proceeds of the PTE.

Background

The TCJA imposed a $10,000 limitation on the amount of SALT that individuals may deduct for federal income tax purposes, beginning with the 2018 tax year. Several states responded by enacting various workaround mechanisms in an effort to mitigate the impact of the limitation on their residents, some of which have already been disallowed by the Internal Revenue Service (IRS). Other states, including Connecticut,³ Louisiana,⁴ Oklahoma,⁵ Rhode Island⁶ and Wisconsin⁷ enacted PTE tax regimes in order to shift the imposition of the tax on PTE income from the owner to the PTE. These mechanisms have not been expressly disallowed by the IRS to date.

New Jersey previously attempted to circumvent the SALT limitation by providing a mechanism enabling resident property owners to offset their property tax bills by donating to state-run municipal funds and school districts.⁸ This workaround was rendered invalid by Treasury regulations⁹ adopted in August 2019, in which the IRS viewed the “tax credit for donation” exchange as a quid pro quo arrangement, which has been held under case law as ineligible for a charitable deduction for federal income tax purposes.¹⁰ New Jersey, along with four other states, filed a lawsuit against the federal government challenging the constitutionality of the SALT deduction cap, but recently lost in federal district court.¹¹

Mechanics of the BAIT

Effective for tax years beginning on or after Jan. 1, 2020, a PTE with at least one member subject to New Jersey Gross Income Tax (GIT) on that member’s share of distributive proceeds¹² of the PTE may elect to be liable for and pay the BAIT.¹³ Under the legislation, a “pass-through entity” is defined as a partnership, New Jersey S corporation or limited liability company classified as a partnership for federal income tax purposes.¹⁴ PTE members then receive a credit equal to the member’s pro rata share of the tax paid. Non-corporate members will receive a refundable credit against GIT liability,¹⁵ while corporate members will receive a credit against CBT liability that may be carried forward for up to 20 years.¹⁶

For a valid election to occur, all members of the PTE must consent to the election, or an officer, manager or member authorized by the PTE to consent to the election, such as a tax matters partner.¹⁷ The PTE must make the election on an annual basis, prior to the original due date of the PTE’s tax return, not the extended due date.¹⁸ No retroactive elections may be made after the return’s original due date, and any revocation of the BAIT election must be made before the original due date of the PTE return.¹⁹

Once a PTE elects to be subject to the BAIT, tax is imposed according to a tiered rate structure depending on the sum of the PTE members’ share of the distributive proceeds for the tax year:

• 5.675% of the sum of each member’s share of distributive proceeds attributable to the PTE for the tax year, if the sum of each member’s share of proceeds is $250,000 or less
• $14,187.50 plus 6.52% of the excess amount over $250,000, if the sum of each member’s share of proceeds over $250,000 but not over $1 million
• $63,087.50 plus 9.12% of the excess amount over $1 million, if the sum of each member’s share of proceeds is over $1 million but not over $5 million
• $427,887.50 plus 10.9% of the excess amount of over $5 million, if the sum of each member’s share of proceeds is over $5 million²⁰
• ²⁰

The law also allows PTEs that are commonly owned by a related group of individuals, estates or trusts to file a combined BAIT return.²¹

PTE members may claim a refundable GIT credit equal to 100% of the member’s pro rata share of the BAIT paid by the PTE.²² The credit is applied to the member’s original GIT liability in the same tax year after all other tax credits are utilized by the member. Any excess credits are viewed as an overpayment without accrual of interest.²³ New Jersey resident members may claim a credit for taxes paid to another state or political subdivision on income subject to the BAIT.²⁴ The credit may not exceed the proportion of the tax otherwise due that the amount of taxable income in the other jurisdiction bears to the member’s entire New Jersey net income.²⁵ Additionally, a resident taxpayer may claim a credit for a tax paid to another state or political subdivision that the New Jersey Division of Taxation (Division) determines to be “substantially similar to” the BAIT, not to exceed the amount allowed if the income were taxed at the individual level.²⁶

An electing PTE must make estimated payments on or before the 15th day of the fourth, sixth and ninth month of the tax year and the 15th day of the first month of the following tax year. The actual return and tax payment is due on or before the 15th day of the third month after the close of the PTE’s tax year.²⁷

S corporation rules

The legislation stipulates that initial shareholders of a federal S corporation must consent to New Jersey S corporation treatment for the PTE in order to elect the BAIT regime.²⁸ For shareholders that join the S corporation at a later date and do not consent to S corporation treatment, the state may collect tax from the S corporation on behalf of the non-consenting shareholders.²⁹ Ultimately, the S corporation may recover the payments from non-consenting members, being free from a BAIT collection requirement with respect to its non-consenting members.³⁰ S corporations have the ability to revoke the BAIT election on or before the last day of its tax year.³¹

Interaction with CBT The BAIT is generally separate from any other tax due and paid by the PTE under the New Jersey CBT. PTEs opting to file the BAIT are includible in a combined group and must file a combined CBT return, unless all the PTE members are all subject to GIT, or no business entity taxed as a corporation under the CBT has direct, indirect, beneficial or constructive ownership or control of the PTE.³²

In the case of PTEs having both corporate members and non-corporate members, corporate members of a PTE may claim the BAIT credit against their CBT liability and temporary surtax to the extent of the statutory minimum tax due.³³ Any excess BAIT credit may be carried forward for 20 years.³⁴ If the corporate member is exempt from CBT, then the member’s share of BAIT credit may be fully refunded.³⁵

Finally, if the PTE is in a unitary business with both a corporate member and its combined group, the BAIT credit can be shared among all combined group members.³⁶ However, if the PTE is unitary with the corporate member, but not its combined group, the BAIT credit applies only against income derived from the corporate member’s business activities, independent of the unitary business activities of the combined group.³⁷

Liability

The BAIT legislation specifies that a partnership and its partners are jointly and severally liable for BAIT obligations, with two exceptions: (i) the partners are not liable for PTE obligations that were incurred before their admission into the partnership; or (ii) obligations incurred while the partnership is a limited liability partnership in which those obligations are solely of the limited liability partnership.³⁸ The legislation directs that taxes collected under the BAIT are to be deposited in the state’s general fund.³⁹

Commentary

The New Jersey BAIT was enacted with widespread support from the state legislature and the state’s certified public accountant society, recognizing a need to assist smaller New Jersey businesses that are negatively affected by the $10,000 SALT deduction limit. It is estimated that the new law will save the approximately 290,000 New Jersey pass-through businesses anywhere from $200 million to $600 million annually on their federal tax bills.⁴⁰ It should be noted that the PTE tax regime is not a new concept in New Jersey, as New Jersey PTEs previously paid state income tax liability on behalf of their members until the tax was repealed in 1993.

New Jersey’s PTE tax legislation is largely modeled after the PTE tax laws recently enacted in Connecticut and other states. Unlike the Connecticut PTE tax, however, the BAIT is an optional tax rather than mandatory, and it remains to be seen whether the voluntary nature of the optional PTE taxes will impact the IRS and the Treasury Department’s decision to address the federal treatment of these new tax regimes. Another notable difference from the Connecticut PTE tax is the fact that New Jersey PTE members are allowed a full credit against their GIT liability equal to the pro rata share of the tax paid by the PTE. In contrast, Connecticut allows a credit equal to the PTE owner’s pro rata share of the tax paid, multiplied by 87.5%.⁴¹ The real beneficiaries of the legislation would mainly be the resident members of a PTE having significant presence in New Jersey, to which a greater share of income may be allocated. Because the PTE pays tax only on New Jersey connected income, the corresponding credit for such tax may be less than the owner’s GIT liability for a PTE having income from both in-state and out-of-state sources.

By paying tax at the entity level, members of the PTE are deducting expenses and taxes incurred by the trade or business (i.e., an above-the-line deduction) versus a conventional below-the-line deduction at an individual level that would be subject to the SALT limitation. Whether the IRS issues new regulations addressing this new workaround remains to be seen, as the agency issued proposed regulations on the charitable contribution workaround in December 2019, but has remained silent on how the SALT cap interacts with PTE taxes. In the event new regulations are issued, it is possible that New Jersey and similar states would file suit for injunctive relief in a similar fashion as they did last year, attempting to block regulations halting the charitable contribution workaround.

The PTE tax law presents a number of unanswered questions. One wrinkle is how a corporate PTE member will obtain CBT credit for its share of BAIT paid from the PTE, if the PTE income is included in the combined group’s taxable base when the PTE is unitary with its member. While resident taxpayers may claim a credit for taxes paid to another state or local jurisdiction on income subject to the BAIT, the question remains whether other states will allow a reciprocal credit for BAIT paid by the PTE. Another area of concern is how an entity has the ability to elect the BAIT regime at the end of a tax year where the requirement for estimated payments is ongoing in the current tax year, which may immediately result in a potential underpayment of estimated tax. In that scenario, the PTE would be better served to decide whether to elect BAIT treatment early in the tax year in order to avoid penalties for underpayment of estimated tax paid.

Finally, the legislation raises new questions regarding the BAIT’s interaction with New Jersey’s already complex PTE tax regime, particularly with respect to the mandatory tax that PTEs are required to pay on behalf of their nonresident corporate and individual owners.⁴² Major questions requiring the Division’s attention include whether PTEs would still be responsible for remitting tax on behalf of nonresidents in the event they elect BAIT treatment, and whether nonresident members would still have a GIT filing obligation when the PTE is their only source of New Jersey income. The Division will also need to address other resulting issues created by the new tax, such as apportionment factor calculations for combined groups including both PTEs and corporations, and other mechanical tax reporting issues. Further guidance from the Division on these important questions is expected in the coming months.

1 P.L. 2019, c.320 (S. 3246), Laws 2020.
2 P.L. 115-97.
3 Act 18-49 (S.B. 11), Laws 2018. The first state to enact a PTE tax, Connecticut is currently the only state to impose a mandatory business entity-level tax. For further discussion of this tax, see GT SALT Alert: Connecticut legislation responds to federal tax reform; and GT SALT Alert: Connecticut amends entity tax provisions.
4 Act 442 (S.B. 223), Laws 2019; LA. REV. STAT. § 47:287.732.2(A)(1). For further discussion, see GT SALT Alert: Louisiana enacts optional pass-through tax.
5 H.B. 2665, Laws 2019.
6 Ch. 88 (H.B. 5151), Laws 2019.
7 Act 368 (S.B. 883), Laws 2018.
8 P.L. 2018, c.11, Laws 2019.
9 Treas. Reg. § 1.170A-1.
10 U.S. v. American Bar Endowment, 477 U.S. 105, 116-18 (1986).
11 New York v. Mnuchin, No. 18-CV-6427 (S.D.N.Y. 2019).
“Distributive proceeds” are defined as net income, royalties, interest, rents, guaranteed payments, and gains of a PTE, derived from or connected with sources in New Jersey, and upon which tax is imposed and due on a member of the PTE under New Jersey GIT law. P.L. 2019, c.320 (S.B. 3246), § 2.
12 S. 3246, § 3.a.
13 S. 3246, § 2.
14 S. 3246, § 5.a.
15 S. 3246, § 11.
16 S. 3246, § 3.b.(1).
17 Id. The due date for PTE returns is the 15th day of the third month following the close of the tax year, or March 15 for calendar year taxpayers. § 3.d.
18 S. 3246, § 3.b.(1).
19 S. 3246, § 3.b.(2).
20 S. 3246, § 3.c.(2).
21 S. 3246, § 5.a.
22 S. 3246, § 5.c.
23 S. 3246, § 8, amending N.J. REV. STAT. § 54A:4-1(a).
24 S. 3246, § 8, amending N.J. REV. STAT. § 54A:4-1(b).
25 S. 3246, § 8, amending N.J. REV. STAT. § 54A:4-1(f).
26 S. 3246, § 3.d.
27 S. 3246, § 6, amending N.J. REV. STAT. § 54:10A-5.22.b.(1).
28 S. 3246, § 6, amending N.J. REV. STAT. § 54:10A-5.22.b.(3).
30 Id.
31 S. 3246, § 6, amending N.J. REV. STAT. § 54:10A-5.22.d.
32 S. 3246, § 3.c.(1).
33 S. 3246, § 11.
34 Id.
35 S. 3246, § 11.e. An “exempt corporate member” is defined as a member that is not an individual, estate or trust subject to GIT, or corporation that is exempt from CBT. S. 3246, § 11.f.
36 S. 3246, § 11.c.
37 S. 3246, § 11.d.
38 S. 3246, § 10, amending N.J. REV. STAT. § 42:1A-18.a, .b.
39 S. 3246, § 4.b.
40 John Herzfeld, ‘IRS-Proof’ SALT-Cap Workaround Heads to New Jersey Governor, BLOOMBERG BNA DAILY TAX REPORT: STATE, Dec. 17, 2019.
41 CONN. GEN. STAT. § 12-699(g)(1)(A), (B).
42 N.J. REV. STAT. § 54:10A-15.11(a)(1).