Proposed Tax Bill Affecting New Jersey Pass-Through Entities
The proposed bill “Pass-Through Business Alternative Income Tax Act” was passed by the New Jersey Senate Committee retroactively beginning with 2018 taxable years.
In most states, pass-through businesses do not pay income tax at the entity level. Instead, the entity’s income and losses are “passed-through” to their owners and taxed as part of the owner’s individual or corporate tax return. The New Jersey (NJ) approval of the proposed bill allows for the election for entity level tax, with a refundable income tax credit.
New Jersey is not alone in enacting a pass-through business entity level tax. Similar legislation has been considered and enacted in Connecticut, New York, Oregon and other states. The new pass-through entity (PTE) tax is expected to be fully deductible for federal income tax purposes, with a corresponding tax credit offset at the shareholder, partner or member’s (individual) level.
The Tax Cuts and Jobs Act (TCJA), introduced a provision to disallow itemized deductions for state and local taxes (SALT) of more than $10,000. The SALT limitation was anticipated to have a negative effect on business owners operating as pass-through entities; thus, motivating states such as NJ to propose a remedy. However, if the new law goes into effect, it should result in net tax savings for NJ business owners. NJ business owners will not be as adversely affected by the new business tax because NJ is converting a non-deductible state income tax from the disallowance on the taxpayer’s individual tax return into a deductible business expense.
Proposed Tax Brackets
The four tax brackets on the entity level tax will range as follows:
- 5.25% if distributive proceeds from pass-through entity are less than $250,000
- 6.37% if distributive proceeds from pass-through entity are less than $1,000,000, but greater than $250,000
- 8.97% if distributive proceeds from pass-through entity are less than $3,000,000, but greater than $1,000,000
- 10.75% if distributive proceeds from pass-through entity are greater than $3,000,000
(Please note that distributive proceeds are income, dividends and gains of the pass-through entity).
The credit will be equal to 89.25% of the owner’s distributive share of the entity level tax. If the credit exceeds the tax, that excess will generally be refundable. The credit is permitted to any trust or estate and may be allocated to beneficiaries or be used against the tax liability of the estate or trust.
There are still many questions regarding the entity level tax. For example, what happens with non-resident individuals of an entity that are generally not required to file a personal income tax return for tax years in which the pass-through is their only source of income and the pass-through has paid the entity tax? What happens in cases when the individual’s nonresident tax credit is not enough to fully cover the personal income tax liability?
In addition, in making this election, pass-through entities will need to consider the potential loss of member’s resident state tax credits in other states, which could result in effectively paying tax both at the entity and the individual resident levels. States will need to determine whether they will permit the residents to receive credit for the non-resident PTE-level tax imposed on pass-through income in another state. Most importantly, what is the proper treatment of tiered business entities? Will the IRS treat the election as a withholding and then negate the benefits put in place to avoid the SALT limitation?
Count on the Herbein tax team to keep you informed as more details become available. For more information, please contact a member of the Herbein tax team, or email us at firstname.lastname@example.org.
Article prepared by: Maria D. Stromple