State Tax Entity Election Updates to Know for Year-End

Specifically as it applies to Illinois taxpayers

As we patiently await news on the “Build Back Better” (BBB) legislation, we wanted to share, in the meantime, a quick update regarding one specific planning opportunity that you may wish to consider before year-end.

State & Local Tax (SALT) Caps

A lot of conversation in Congress has surrounded raising the State and Local Tax (SALT) cap, which is the itemized deduction for state taxes. In one of the latest iterations, an increase to $80,000 (from $10,000) was considered for married filing-joint taxpayers.

It remains likely that, although many significant tax increases were removed from the draft of the bill, in one way or another, the final version of the bill will include some type of increase in taxes. Taxpayers making more than $400,000 per year will more than likely fall victim to these increases. Nonetheless, favorable tax changes, including the above-mentioned SALT cap increase, are expected to appear in the final bill, too. While there is much uncertainty as to whether the bill will pass at all, let alone before year-end, it’s important to keep track of the progression and action of this bill.

State Workaround Legislation

Areas to currently pay mind to are laws that have already passed by states and are in effect for the 2021 tax year. Related to the SALT cap mentioned above, many states, including Illinois, have instituted state tax work-around legislation.

Essentially, the Illinois workaround law will allow a pass-through entity to pay at the entity level and take as an ordinary deduction state taxes normally paid by the shareholder or partner of the pass-through entity. This option allows state taxes attributable to the income from the electing pass-through entities to avoid the federal state tax itemized deduction limitation. Further, in order to avoid double taxation, shareholders or partners will be able to claim a credit equal to their portion of the tax paid at the entity level (or some states, like Wisconsin, will exclude the pass-through entity income). So long as Congress does not eliminate the SALT cap altogether under the BBB, this is a beneficial election to consider when filing your business returns for the tax year 2021.

IRS Treatment

We should note that there is one somewhat unique component to this pertaining to the IRS and how they intend to treat these types of state workaround laws. The IRS issued Notice 2020-75, indicating that they would not challenge the state tax expense claimed by an entity, provided certain criteria are met, including that the tax must be paid in the tax year for which the deduction is being claimed for the expense. The IRS indicated in this notice that if the benefit is taken with a 2021 return for the deduction, the tax must be paid before year-end, even for accrual basis taxpayers. The IRS may ultimately clarify their position on this later on, but for now, this is the guidance we should follow.

Under this guidance, you may consider estimating your tax liability and making this payment in December before the year ends, so that you can claim it as a deduction on an entity return for 2021. However, this option is not as automatic as it may seem. Delaying the payment will not mean a loss of the deduction, but rather only a one-year delay of such deduction. And with the uncertainty regarding the new tax law and the real possibility of increased tax rates after 2021, it may actually be the smart play to take the wait-and-see approach, thus delaying payment but also delaying the deduction into a tax period with a potentially higher tax burden.

For more information or to evaluate which option is best for your business, please talk to our tax team:

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