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‘IRS-Proof’ SALT-Cap Workaround Heads to New Jersey Governor

Dec. 17, 2019, 7:22 PM

A New Jersey bill to give small businesses and partnerships a way to blunt the impact of the federal cap on state and local tax deductions is headed to Gov. Phil Murphy (D) for approval.

The bill (S-3246/A-4807) would give S corporations, limited liability corporations, and other business partnerships the option of paying state income tax directly at the entity level, as a business tax—rather than at the partner level, as personal income tax. It passed both houses of the New Jersey Legislature by unanimous votes Dec. 16, as part of a lame-duck session following the November elections and leading up to a Jan. 13 adjournment.

The legislation would take advantage of the fact that, while the Tax Cuts and Jobs Act capped federal deductions for state and local tax at $10,000 for individuals, it set no limit on deductions for state and local taxes paid by businesses. It was backed by the New Jersey Business and Industry Association and the New Jersey Society of Certified Public Accountants, which urged the governor to sign it.

A spokesman for Murphy didn’t immediately respond to a request for comment on the bill.

The impact of the bill would be “tremendous for New Jersey,” said Alan D. Sobel, managing member of SobelCo in Livingston, N.J., and president-elect of the state CPA organization, which helped to design the legislation. He estimated the savings to taxpayers at $200 million to $600 million a year, depending on how they’re spread across different tax brackets.

“The tax savings will come from the federal side, but it’s revenue-neutral to New Jersey,” Sobel said in a Dec. 17 interview. “That’s the beauty of it.”

Until 1993, businesses paid the state income tax liability of their partners and owners directly to the state. The new legislation would bring the practice back as an option. Taxable income of S corporations, LLCs, and partnerships—known as pass-through entities—is currently reported on a member’s personal tax return, and taxes are paid by the individual.

The bill is “IRS-proof,” sponsors said.

“This provides a ‘Back to the Future’ solution to the federal cap on SALT deductions for potentially hundreds of thousands of small business owners and partners,” state Sen. Paul Sarlo (D) said in a statement. “It would be hard for the IRS to challenge our state’s prerogative to return to a tax system that was in place for 17 years.”

The New Jersey bill is modeled on a Connecticut law passed in 2018, he said.

It’s unclear what the IRS response to the bill will be, but opposing it would require changing longstanding principles in the federal tax code on deducting entity-level state business taxes, Sobel said.

An Internal Revenue Service rule proposed Dec. 13 addresses SALT-cap workarounds but didn’t address the pass-through entity approach, noted Richard D. Pomp, a law professor at the University of Connecticut.

“How to interpret that silence?” he asked in an emailed comment Dec. 17. “Is it an implicit endorsement of what New Jersey has just done? Wisconsin and Connecticut already have taxpayers filing returns under regimes similar to New Jersey’s. We might have expected that if the IRS was going to challenge these, it would have given taxpayers notice in this proposed regulation—or it may just represent internal conflict within the service.”

The bill could save billions of dollars for the estimated 115,000 New Jersey small businesses that are registered as S corporations and pay their business taxes through the state personal income tax, sponsors said. It would also apply to 175,000 law firms, medical groups, accounting practices, and other partnerships created as LLCs, they said.

Partnership income accounted for $23.4 billion in state income tax revenue in 2015, while S corporation income totaled $11.9 billion, sponsors said, citing the most recent state Treasury statistics.

The bill sat at the Assembly committee level for nearly a year before final passage, but the logjam broke in October after sponsors and supporters assured state tax officials that it wouldn’t result in any revenue leakage, Sobel said.

To contact the reporter on this story: John Herzfeld in New York at jherzfeld@bloomberglaw.com

To contact the editors responsible for this story: Jeff Harrington at jharrington@bloombergtax.com; Kathy Larsen at klarsen@bloombergtax.com

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