(For clarity purposes, this write-up focuses on S corporations.  The arguments and policy conclusions largely apply to partnerships as well.)

Like C corporations, S corporations are subject to state and local income taxes imposed on qualified business income.  Unlike a C corporation where the state and local income tax is incurred and paid at the entity level, however, an S corporation remits its share of state and local income taxes in three different ways, depending on the state:

  1. Entity Level State & Local Tax Income Liability
  2. Composite/Withholding State & Local Income Tax Liability
  3. Individual State & Local Income Tax Liability on Business Income

The legislative history of the Tax Cuts and Jobs Act makes clear that for S corporations operating in states using method 1, those taxes would continue to be deducted at the entity level, resulting in less taxable income being passed through to the shareholders.  The result is that in states that utilize that method, those taxes remain deductible.

In states where the S-Corp is required to pay under methods 2 and 3, however, those taxes would not be deductible under the new tax law (subject to the new, $10,000 limitation).  The result is an increase in the effective marginal rates of those businesses of two, three, or even four percentage points, depending on the state and the level of tax.

The problem, of course, is that most S corporations are subject to State and local income taxes under methods 2 and 3.

States interested in making their tax codes more business friendly should pay attention.  By shifting the incidence of tax from the shareholder to the entity, states can significantly reduce the tax burden on their resident S corporations (and partnerships), all at no cost to their treasury.

How We Got Here

Early in the debate over the Tax Cuts and Jobs Act, there was significant confusion within the business community and among members of Congress as to exactly what policy was being debated – would S corporations be able to deduct their business income taxes?  Over time, it became apparent that the Tax Cuts and Jobs Act would suspend the deduction for State and local income taxes levied on S corporation income paid at the shareholder level.  But what about those taxes paid at the entity level?

The final language of the new law says, “The [limitation on SALT deductions] shall not apply to … any taxes described in paragraph (1) and (2) of subsection (a) [of Section 164] which are paid or accrued in carrying on a trade or business or an activity described in section 212.”  Paragraph (1) of Section 164 refers to real property taxes, while paragraph (2) refers to personal property taxes.  Left out of this language is paragraph (3) [State and Local income taxes].

The Conference Report accompanying HR 1 says “Under the provision, in the case of an individual, State and local income, war profits, and excess profits taxes are not allowable as a deduction.”  This language makes clear that State and local income taxes paid by S corporation shareholders are no longer deductible on their Federal returns (subject to the new $10,000 limitation).

Footnote 172 of the Conference Report, however, states: “[T]axes imposed at the entity level, such as a business tax imposed on pass-through entities, that are reflected in a partner’s or S corporation shareholder’s distributive or pro-rata share of income or loss on a Schedule K-1 (or similar form), will continue to reduce such partner’s or shareholder’s distributive or pro-rata share of income as under present law.”

So, taxes paid by the entity are deductible, while those paid by the shareholder are not.  This outcome results in two disparities for S corporations.

First, S corporations operating in states where State and local income taxes are paid at the shareholder level are disadvantaged compared to businesses operating in the state as C corporations.  Under the new law, C corporations continue to deduct these taxes while S corporation do not.  No policy rationale for this distinction has ever been articulated.

Second, those same S corporations are disadvantaged compared to S corporations operating in other states with 1) no State or local income taxes or 2) an entity-level tax that remains deductible.

Activity by the States

In recent weeks, two states have announced efforts to address this disparity by shifting their taxation of S corporations from a shareholder-level tax to an entity-level tax.

The first state to move was Connecticut, where the Governor proposed, as part of a broader package of reforms, to shift the incidence of the state income tax on business income from the shareholders to the business entities.  You can access the legislative proposal and related materials here:

The Connecticut proposal includes the following three key changes:

  • Impose a tax on pass-through businesses equal to the individual state income tax rate of 6.99 percent;
  • Give pass-through owners a tax credit equal to the amount (6.99 percent x 93.01 = 6.5 percent) to protect them being double-taxed on their business income; and
  • Adopt rules to recognize similar tax credits from other states to business owners living in Connecticut.

The proposal’s effect would be to reinstate the SALT deduction on pass-through business income by adopting method 1 and apply the tax at the entity rather than the shareholder level.  The math works like this:

As you can see from the table, for S corporation owners who do not qualify for the new 20-percent pass through deduction, their taxes go up under the new tax overhaul – from 39.6 percent to 39.8 percent.  The Connecticut proposal would eliminate this tax hike and replace it with a small reduction.  For businesses that qualify for some or all the new 20-percent pass through deduction, their rate would be lower.

Having reviewed the approach taken by Connecticut, our advisors have suggested several friendly amendments.  Specifically, we recommend the proposal:

  • Allow for S corporations and other pass-through businesses to elect out of the new, entity-level tax. There are a number of reasons why a pass-through business may choose not to be taxed at the entity level.  They should be given that flexibility.
  • Change the refundable credit for tax paid by a pass-through entity to a credit that can be carried forward indefinitely.
  • Add clarifying language for pass-through ownership with multiple tiers.
  • Limit the credit for taxes paid to other states to residents and part-year residents, as is the current credit for personal income taxes paid to other states.
  • Clarify the way the tax on S corporations should be computed by referencing the S corporation provisions, instead of the partnership provisions.

You can read the full summary of proposed amendments here, and the resulting legislative text here.

Connecticut has now been joined by New Jersey, where a bipartisan group of Senators announced this month they would introduce legislation along the same lines as Connecticut’s SB 11.

The business community should support these efforts. There is no policy rationale for allowing one group of businesses – C corporations – to deduct their state and local taxes while blocking other businesses – S corporations and other pass-throughs – from doing the same.  These taxes are an obvious cost of doing business and should be treated as such.

To be clear, our support doesn’t mean this is the best of all policies.  Writing in Forbes, Howard Gleckman of the Tax Policy Center observed that these proposals were “intriguing” but also noted:

By flipping the tax treatment of partnerships and the like on their head—effectively taxing the entity but not the owner, such a plan raises a million questions. Here are just three: How will out-of-state business owners be treated? What is being billed as a plan aimed at helping the owners of pass-through firms effectively open the door to something very different—double state-level taxation of partnerships and similar businesses? And what should we call these firms? After all, once they are taxed at the business level, they really are not pass-throughs anymore.

The first question is answered by the proposals – they would recognize the tax credits passed on to S corporation shareholders by other states when they shift to an entity level tax.  The more states that adopt this policy, the less concerning the out-of-state shareholder issue will be.  Those credits largely address the second concern as well, by ensuring that the shareholders of affected S corporations are shielded from the double tax.

The third concern is more philosophical but also more challenging.  If the new tax law forces states to abandon pass-through tax treatment, it continues the general trend started by the tax overhaul to shift business activity out of the correct pass-through model.  That’s not good for tax policy, nor is it necessarily good for the Main Street business community, but it’s a trend driven by the tax overhaul itself, not the pass-through SALT fix.

An Opportunity for Other States

As noted, shifting the incidence of S corporation taxation at the state level from the shareholder to the entity can result in a significant reduction in the effective marginal tax rates paid by S corporations operating in that state.  The reforms under consideration in Connecticut and New Jersey would comport with the structure of the new tax overhaul and can be enacted in a manner that has no net effect on a state’s tax collections.

To help encourage these efforts, S-Corp has put together the following resources:

Encouraging states to shift to entity-level taxes is not S-Corp’s preferred policy.  The correct policy is for the Federal Tax Code to allow pass-through owners to continue to deduct these taxes as a legitimate business expense.  We will continue to press for this change at the Federal level.  In the meantime, however, the States have it within their power to address this new disparity and make their respective tax policies more attractive to their own Main Street businesses.  They should exert this authority and take advantage of this opportunity.