In January 2020, New Jersey passed a law that allows pass-through entities to pay income tax at the entity level.
What’s the law? What does this mean?
Most pass-through entities are owned by an individual or group of individuals. Income that the business earns flows through to the owners and the owners pay tax on it.
New Jersey’s law, the Pass-Through Business Alternative Income Tax Act, is changing things up. This law allows the business to pay income tax to the state of New Jersey, not the owners.
In 2017, the Tax Cuts and Jobs Act limited individual taxpayers to a $10,000 deduction for state and local taxes on their federal income tax return.
So, when taxpayers add up the personal property taxes or real estate taxes they pay to states, they can only claim a $10,000 deduction if they itemize deductions. Even if they paid more than $10,000 in state and local taxes.
Does this limitation impact many taxpayers? Maybe not.
For tax filers with incomes exceeding $100,000, their average claim was about $21,000. Members of that group probably aren’t happy with this limitation. Plus, more taxpayers may have elected to itemize their deductions if this limitation wasn’t created in 2017.
According to the Tax Policy Center, “Less than one-third of tax filers opted to itemize deductions on their federal income tax returns in 2016, but virtually all who itemized claimed a deduction for state and local taxes paid.”
Cue New Jersey.
New Jersey is giving taxpayers a way to work around this limitation by allowing pass-through entities to pay income tax instead of the individual. It could help taxpayers who have ownership interest in pass-through entities maximize their state and local tax deduction on their personal federal returns.
Who does this benefit?
Fortunately, this law isn’t mandatory. It’s up to owners to make the election. Owners include the shareholders of S corporations, partners in a partnership, and members of an LLC.
If they benefit from the entity paying New Jersey income tax and it helps them avoid the $10,000 deduction limit, they may want the entity to pay the income tax.
If the owners frequently exceed the $10,000 deduction limit, they may want to shift the tax responsibility to the entity so they benefit from a greater deduction and more tax savings on their personal federal income tax return.
In addition, owners can claim a refundable credit for their share of the tax paid on their personal return. If they receive an excess credit, they can carry it forward for 20 years.
How does New Jersey define pass-through entities?
A pass-through entity is a partnership, an S corporation, or a limited liability company (LLC) with at least one member who is liable for tax on distributive proceeds pursuant to the New Jersey Gross Income Tax Act.
Single-member LLCs, sole proprietorships, and entities with no income aren’t eligible for this election.
What happens if an entity makes this election?
First, all owners must agree to make the election. Then, the owners or a member who has the authority to make the election for all members must make the election annually by March 15, the entity’s return due date.
How much will the business pay in taxes?
The company’s tax is based on the sum of each partner’s distributive proceeds which include:
- net income
- guaranteed payments
All distributive proceeds must be derived from or connected with sources within New Jersey.
The following table outlines the tax the entity must pay based on the sum of the partners’ distributive proceeds. Distributive proceeds are synonymous with the entity’s total income.
|$0 - $250,000||5.675%|
|$250,001 - $1 million||$14,187.50 base + 6.52% of amount more than $250,000|
|$1,000,001 - $5 million||$63,087.50 base + 9.12% of amount over $1 million|
|More than $5 million||$427,887.50 + 10.90% of amount over $5 million|
Also, the entity must annually report each member’s share of distributive proceeds for the taxable year.
Can I see an example?
Of course! Let’s say you’re a New Jersey resident and you’re a 25% shareholder in an S corporation.
All shareholders agree to have the entity pay tax. The sum of the shareholders’ distributive proceeds is $500,000. 100% of proceeds come from New Jersey. Here’s what the business will pay in taxes.
For the first $250,000 of distributive proceeds:
$250,000 x 100% (1.0) x 5.675% (.05675) = $14,187.50
For the next $250,000 of distributive proceeds:
$250,000 x 100% (1.0) x 6.52% (.0652) = $16,300.00
Add both amounts for the total tax due:
$14,187.50 + $16,300.00 = $30,487.50
Because the sum of proceeds is greater than $250,000, the proceeds are subject to two different tax rates. The entity pays a total of $30,487.50 of income tax to the state.
Since you have a 25% stake in the business, you’ll receive a refundable tax credit. Here’s the calculation:
$30,487.50 x 25% (.25) =$7,621.88
You’ll also pay tax on your share of distributive proceeds you earned from the business.
$500,000 x 25% (.25) = $125,000
Finally, you’ll apply your tax rate to your share of distributive proceeds – $125,000. Let’s say you file as married filing jointly and your New Jersey income tax rate is 6.37%. Your tax due is $7,962.50.
$125,000 x 6.37% (.0637) = $7,962.50.
When does this law go into effect?
This law is effective for tax years beginning on or after January 1, 2020. Since 2020 is the first year this option is available, taxpayers won’t be penalized for failing to file or make estimated tax payments this year.
What should I do next?
Talk with a tax professional and the co-owners of your pass-through entity about this law. Should you make the election for 2020? Does the group of owners agree?
If yes, move forward with making the election. If not, no action is needed. But, continue to pay attention to the income earned at the business level and how it affects your individual taxes.
Maybe 2020 isn’t the right year to make the election, but it may be a strategic tax move in a future year.
Have questions about how this law affects your tax liability and business? Let’s talk!