New federal tax guidance can permit S corporations and partnerships to deduct some tax payments on business income paid to state and local governments—a long-sought local tax break.

The state and local tax (SALT) deduction permits taxpayers who itemize when filing federal taxes to deduct certain taxes paid to state and local governments. The Tax Cuts and Jobs Act capped it at $10,000 per year.

The guidance (Notice 2020-75) will permit partnerships and S corps—pass-through business entities that pass income on to the owners—to deduct state and local income taxes, essentially freeing individual partners and shareholders from SALT caps if they itemize deductions. The guidance also permits retro-application to tax years after Dec. 31, 2017.

This “effectively shifts state and local income tax payments from the individual owners of a pass-through entity ... on to their pass-through entities, where there’s no limitation for the SALT deduction,” said James G. McGrory, a CPA and shareholder at Drucker and Scaccetti in Philadelphia.

Seven states—Connecticut, Louisiana, Maryland, Oklahoma, Rhode Island, Wisconsin and New Jersey—have created entity-level taxes for pass-through entities; more states are expected to follow. The entity-level tax in six of the states is elective. In Connecticut, it’s mandatory.

This guidance might affect clients in wealthy areas especially. Lawrence Pon, a CPA amd advisor in Redwood City, Calif., said many clients in his area are upset about the $10,000 SALT deduction limit “since the property tax on many homes in Silicon Valley is at least $10,000.”

Taxpayers can rely on this guidance even though the proposed regulations haven’t yet been issued, McGrory said.

Taxes paid on a taxpayer’s behalf will be included as a pass-through item on their K-1, and owners will be able to claim them as a payment on their state tax return. “Each partnership or S corporation that wishes to participate in this program will need to make a yearly election,” added Gail Rosen, a CPA in Martinsville, N.J.

“This is big news and very favorable guidance for clients in states with high state and local income tax rates,” McGrory said, adding that it’s still important to run the numbers to see if it’s better to pay SALT at the entity level or at the individual level. Drucker and Scaccetti also strongly recommend that all the management of a company discuss the election as it could hurt some owners’ individual tax situations.

For example, New York doesn’t recognize pass-through entity payments as taxes paid on a resident’s behalf. “The result will be double taxation,” Rosen said.

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