IRS Clarifies the Deductibility of Payments by Partnerships and S Corporations for Certain State and Local Income Taxes

On November 9, 2020, the Internal Revenue Service issued Notice 2020-75 addressing the deductibility of payments by partnerships and S corporations for certain state and local income taxes. Prior to 2018, Section 164(a) allowed individual taxpayers an itemized deduction for state and local income taxes. Although the Tax Cuts & Jobs Act (TCJA) created section 164(b)(6) to limit this deduction to $10,000, this limitation does not apply to taxes incurred in a taxpayer’s trade or business. This created a situation wherein state taxes assessed to an entity are fully deductible as business expenses whereas composite payments an entity makes on behalf of its owners are treated as itemized deductions subject to the $10,000 limitation.

In response to this perceived inequity, some states have passed legislation imposing entity level taxes, which are intended as “workarounds” to allow full deductibility of these taxes by the partnership or S corporation. Connecticut and New Jersey are two examples of states that have passed such legislation. Although the specific provisions are different, each state allows the pass-through entity to pay the state tax due on the owners’ shares of distributive income as a deductible business expense. The owners can then claim a refundable credit for these taxes paid on their personal returns.

The intention of the proposed regulations outlined in Notice 2020-75 is to provide owners of partnerships and S corporations a level of certainty as to the Federal tax treatment of their state income tax liabilities. Amounts directly assessed to a partnership or an S Corporation will be designated as “Specified Income Tax Payments” and will be fully deductible in calculating its taxable income. In addition, these tax payments will not be taken into account in calculating the $10,000 limitation for any partner in a partnership or shareholder in an S corporation.