The following is the unedited copy of “Five Questions With: Michael Colucci” that appeared in PBN on Tuesday, October 15, 2019. The link to the PBN article can be found [here].
1] How does the Tax Cuts and Jobs Act’s $10,000 cap on itemized deductions for state and local taxes work?
In December of 2017, Public Law 115-97, commonly called the Tax Cuts and Jobs Act (TCJA), was signed by the President. The TCJA significantly changed the tax code for individuals and businesses beginning in 2018.
One of the TCJA provisions limits an individual taxpayer’s deduction for State and local tax (SALT) payments to $10,000 a year or $5,000 per year for a married person filing a separate return. This limitation doesn’t apply if the payments are made in pursuit of a trade or business. These SALT payments include payments for income and property taxes. The law also eliminated foreign real estate property tax payments. Payments that exceed this amount are no longer deductible by individual taxpayers.
Prior to TCJA, there was no limit on personal SALT deductions unless you were subject to the alternative minimum tax. If using the itemized deduction method prior to TCJA, individual taxpayers deducted 100% of their state and local income and property taxes. The change not only effects individuals in higher income tax states but also those that live in high-property-tax jurisdictions or those that may own both a primary residence and one or more vacation homes.
To determine the impact of the limit on SALT deductions, the Treasury reviewed Federal tax returns filed for the 2017 tax year. The Treasury estimated that, had the SALT limitation been in place in Tax Year 2017, it would have affected approximately 10.9 million taxpayers. These taxpayers could not have deducted approximately $323 billion in SALT payments on their Form 1040 Schedule A (Itemized Deduction Schedule). The reduction state and local tax deduction was somewhat offset by other tax cuts in the law, including an increase to the standard deduction and lower tax rates.
2] How does the legislation signed by Gov. Raimondo in July regarding pass-through entities affect the $10,000 cap set by the federal legislation?
The new Rhode Island tax, which is imposed at 5.99% of the pass-through entity’s income, would work around the cap by making the expense a business level deduction. Therefore, the tax will be moved as an itemized deduction on the individual return. The entity level payment may be considered a business expense not subject to the SALT limitation. The payment made to the state will then pass to the entity’s owners and be used as a credit against their individual Rhode Island income tax liability. The owner would increase their RI income by the amount of the entity level tax paid.
The state pass-through entity tax is not mandatory. An election can be made by the pass-through entity each tax year. Initially, the election is made by paying with RI Form RI BUS-EST. The state is still modifying other current tax forms and a future form for making the payment is under development. Also, an entity making the election no longer needs to comply with provisions regarding non-resident withholding.
3] What types of business entities are eligible for that RI pass-through?
The state has set a broad definition of what it considers a pass though entity eligible for the election. According to the law, a qualifying pass-through entity includes a corporation treated as an S corporation for the taxable year, general partnerships, limited partnerships, limited liability partnerships (LLPs), trusts, limited liability companies (LLCs) and certain unincorporated sole proprietorships. Unincorporated sole proprietorships include those that file using Schedule C or Schedule C-EZ (Profit or Loss From Business) or Schedule E (Supplemental Income and Loss From Rental Real Estate and Royalties).
4] What are the different ways the Pass-Through Entity Tax can affect a business’s bottom line?
The pass-through entity tax is set to reduce the federal business income by deducting the entity-level tax paid to RI. The entity is also required to make estimated payments to the state. These payments would have to be considered for cash flow purposes. In addition, if the IRS provides guidance that the payments are non-deductible as a business expense, the entity may have to amend their income tax return and may be subject to penalties and interest.
5] Will either the federal tax cap on itemized deductions or the state pass-through change for the tax years ahead?
The individual limit for the itemized deduction for state and local taxes in the TCJA are set to expire following the 2025 tax year. It is not clear at this time if Congress will extend the law or modify it. Several states have enacted similar legislation as a workaround to the SALT cap. The IRS is expected to issue guidance on whether the entity level it is a valid business expense but it may not come before December 31, 2019.
The Rhode Island law does not have a sunset provision. The entity level tax is voluntary so if IRS guidance is unfavorable, business entities may not want to make the election to pay the entity level tax.
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