In a surprising—but taxpayer-friendly—development, Treasury announced in Notice 2020-75 (available here) that it will be issuing proposed regulations that allow partnerships and S corporations to deduct certain state and local taxes at the entity level. This announcement allows states to mitigate the effect of the limitation on deducting state and local taxes (the SALT deduction cap) imposed by the Tax Cuts and Jobs Act (TCJA) by allowing individuals a full deduction for state and local taxes imposed on pass-through entities.

Effective for tax years beginning after December 31, 2017, the deduction for state and local taxes is limited to $10,000 for individuals who itemize deductions for federal income tax purposes. This limitation disproportionately negatively affects individuals who live in high-tax states.

As an effort to mitigate the negative effect of the federal SALT deduction cap, some states began imposing entity-level taxes on pass-through entities and providing credits to owners of such entities. States with such an entity-level tax include New Jersey, Connecticut, Oklahoma, Louisiana, and Maryland (although the Maryland tax is treated as an entity-level tax only with respect to Maryland resident owners). Many practitioners were skeptical that the IRS would allow pass-through businesses to deduct these taxes to the extent that the individual owners would receive a credit because, economically, these taxes function as taxes on the individual members.

In Notice 2020-75, Treasury announced that it will be issuing regulations allowing partnerships and S corporations to deduct “specified income tax payments” — i.e., any amount paid by a partnership or an S corporation to a state, a political subdivision of a state, or the District of Columbia to satisfy the pass-through entity’s own liability for income taxes imposed by such jurisdiction. Such a deduction will not be subject to the SALT deduction cap, but instead will be allowed as a deduction by the partnership or S corporation when computing its taxable income or loss for the tax year that the specified income tax payments are paid or accrued.

Notice 2020-75 confirms that the specified income tax payments will not be subject to Code Section 702(a), which requires some items (for example, charitable contributions and taxes paid to foreign jurisdictions) to be taken into account separately by each partner rather than used to reduce each partner’s distributive share of partnership income. Therefore, the SALT deduction cap will not limit an individual partner’s ability to reduce taxable income because of specified income tax payments made by the partnership.

Although Treasury did not announce when it would issue the regulations, it stated that partnerships, S corporations and their owners may rely on the Notice with respect to any specified income tax payments made on or after November 9, 2020. Additionally, the regulations will allow a deduction for specified income tax payments made by a partnership or S corporation for any tax years ending after December 31, 2017, made pursuant to a law enacted before November 9, 2020.

As a result of the Notice, many more states, particularly those with high income tax rates, may enact pass-through entity-level taxes as a way of mitigating the effect of the SALT deduction cap on its residents.

Our Tax Group assists clients with questions about IRS Notice 2020-75 and other tax issues.


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