The Tax Cuts and Jobs Act (2017 Tax Act) limited the deduction of state and local taxes to $10,000 for individuals. Several states, including Connecticut, New Jersey and Maryland, have passed legislation that imposed income tax on a pass-through entity (PTE) such as on an S corporation, a partnership or a limited liability company taxed as a partnership. The PTE deducts the income tax, which then reduces the taxable income allocable to the PTE shareholders and partners. The PTE shareholders and partners then typically receive a credit on their state income tax returns for their share of the taxes paid by the PTE.

The Internal Revenue Service (IRS) recently announced in Notice 2020-75 (Notice) that the Treasury Department will issue proposed regulations to clarify that state and local income taxes imposed on and paid by a PTE are deductible at the PTE level, which means that these taxes will reduce the taxable income of the PTE. In operation, the state and local tax deduction will not pass-through to the PTE shareholders and partners, so they will not have these taxes limited by the $10,000 state and local tax deduction amount for individuals. This "workaround" results in no state or local income tax deduction claimed by the PTE shareholders and partners on their federal income tax returns, but since the PTE claims a tax deduction, the PTE shareholders and partners have the same economic benefit because they have reduced taxable income allocated from the PTE.

The Notice also indicates that the deduction at the PTE level applies without regard to whether the imposition of the tax is as a result of an election by the PTE or whether the PTE shareholders or partners receive a partial or full deduction, exclusion, credit or other tax benefit that is based on their share of the amount paid by the PTE. This is helpful since the mechanics adopted by a state will not determine whether the deduction is allowable by the PTE.

The IRS intends that the proposed regulations will apply to payments made on or after November 9, 2020. However, the taxpayers may rely on the provisions of the Notice for payments made during any taxable year ending after December 31, 2017 and prior to November 9, 2020. It is clear that the IRS is accepting the limitation workaround proposals enacted for state and local tax payments made by a PTE, which means that these taxes will not be subject to the 2017 Tax Act $10,000 limitation.

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