New Jersey has enacted legislation creating:
- an elective entity-level alternative income tax for pass-through businesses; and
- an offsetting credit for taxpayers who receive income from a pass-through business that pays the alternative tax.
Pass-through entity taxes like this one are commonly considered a workaround to the federal state and local tax (SALT) deduction limitation.
Elective Entity-Level Alternative Income Tax
New Jersey now allows a pass-through entity with at least one member subject to New Jersey income tax to elect to pay the alternative tax.
In order to pay at the entity level, all members of the entity must agree.
An electing pass-through entity will be excluded from a combined group, and from filing a combined return, if:
- all the members of the pass-through entity are taxpayers otherwise liable for the New Jersey gross income tax; and
- no business entity taxed as a corporation has a direct, indirect, beneficial, or constructive ownership or control of the pass-through entity.
The law takes effect immediately and applies to tax years beginning after 2019.
The tax rate on the share of each distributive proceed is:
- under $250,000, 5.675% of the sum of distributive proceeds;
- over $250,000 but not over $1,000,000, $14,187.50 plus 6.52% of the excess over $250,000;
- over $1,000,000 but not over $5,000,000, $63,087.50 plus 9.12% of the excess over $1,000,000; or
- over $5,000,000, $427,887.50 plus 10.9% of the excess over $5,000,000.
Taxpayers who are members of a pass-through paying the alternative income tax, are allowed a refundable gross income tax credit. The amount of the credit is equal to the member’s pro rata share of the tax paid. The credit is applied against the gross income tax liability of the member in the tax year.
The credit allowed to a trust or estate can be allocated to beneficiaries or used against the liability of the estate or trust.
A corporation that owns a pass-through paying the alternative income tax is allowed a business tax credit. The amount of the credit will equal the member’s pro rata share of the tax paid.
The credit cannot reduce the corporation’s tax liability below the statutory minimum. The credit may be carried forward for up to 20 years.
SALT Deduction Cap
Taxpayers’ federal SALT deduction is limited to $10,000 a year in 2018 through 2025.
States have tried several ways to create a work around to the limitation. The pass-through entity level tax is one of those.
How the Pass-Through Business Alternative Income Tax Functions as a Work Around
Typically, owners of a pass-through entity report taxable income from the pass-through on the member’s personal tax return. Thus, the individuals pay the taxes.
The pass-through alternative income tax shifts state taxes from the individual to the pass-through entity. The pass-through entity then deducts its state and local income taxes as a tax on the business at the federal level. The deduction reduces the income passed on to the individual members.
The owners are then allowed a state credit on their income tax for their distributive share of taxes paid by the pass-through.
Other States Adopting a Pass-Through Business Alternative Income Tax
Other states that have adopted similar pass-through entity taxes include:
Connecticut is the only one these states that has made the pass-through entity tax mandatory.
By Andrew Soubel, J.D.