Entity Level Tax is a Valid Workaround on the $10,000 SALT Limitation

November 13, 2020 by Staff
Copeland Buhl

The TCJA limited the state and local tax (SALT) itemized deduction to $10,000, which essentially increased the federal income tax on many small business owners operating as passthrough entities (PTE) (i.e. partnerships and S corporations).   For federal purposes, a PTE’s income is taxed on the individual income tax return and no income tax is assessed on the PTE.  The TCJA itemized deduction limitation essentially limits the deduction for taxes paid by the owners on business income.  Conversely, C corporations are not subject to the $10,000 limitation and are able to fully deduct taxes paid on business income.

Some states reacted to this limitation by enacting Entity Level Taxes.  An Entity Level Tax is imposed on and paid by the PTE.  The PTE deducts the entire tax paid without the $10,000 cap, same as a C corporation.  Income net of the deduction passes through as ordinary income to the owners (i.e. income reported on Schedule E is after a deduction for the Entity Level Tax).   For federal purposes, the PTE’s deduction for the Entity Level Tax is not subject to the $10,000 SALT limitation. 

The tax community had questioned whether the IRS would allow the PTE to deduct the Entity Level Tax on the business return or if it should be subjected to the $10,000 limitation if the income passes through to an individual.

We now have certainty.  The US Treasury and IRS issued Notice 2020-75 allowing PTE’s to deduct the entire Entity Level Tax as deduction in computing ordinary income without limitation.  The Entity Level Tax must be imposed directly on the PTE.  Mandatory withholding on nonresident owners is not directly imposed on the PTE.  The Notice states the taxes must be paid, not just accrued, by the PTE.  It does not matter if the Entity Level Tax is elective or that an owner would get a credit on their individual state income tax returns. 

This is good news for small businesses.