How New Jersey’s Pass-Through Business Alternative Income Tax Act Can Help Business Owners
Starting in 2020, under New Jersey’s new Pass-Through Business Alternative Income Tax Act, LLCs, partnerships and S corporations will be able to elect to be taxed in New Jersey at the entity level which will create a full deduction of those taxes when computing federal taxable income.
Why Is It Elective?
Adopting this as an elective tax was important to ensure that out-of-state business owners would not get double taxed for the same income in their resident state and thereby maintain the goal of revenue neutrality.
It is typical that states permit credits for income taxes be paid to other jurisdictions to avoid double taxation. Since the New Jersey tax is being paid by the entity, it is not clear how states will interpret and apply the principles of this type of entity tax and the corresponding credit that would have been available if the tax was paid by the individual owner. Therefore, making the alternative business income tax elective permits planning to maximize the potential benefits and avoid the pitfalls of increased taxes.
When the election is made to have an entity-level tax, the individual New Jersey income taxpayers will receive a 100-percent credit for the entity taxes paid against their state of New Jersey taxes to avoid assessing a tax on the same income in the state twice.
There are several circumstances where a business may want to opt out of electing the tax. These include:
- Businesses with non-New Jersey resident owners
- Owners who have multiple businesses that result in an aggregate taxable loss
- Businesses where the cost of making the election (mostly professional time to analyze and complete the filings) will exceed the benefits
- Taxpayers who have a concern the federal government will attack New Jersey’s treatment of the business alternative income tax.
What Will the Future Bring?
Having been a part of the process from the beginning, my expectation is that this law is on reasonably solid footing. Although I am not a lawyer, constitutional scholar or legislative expert, I hold this opinion for the following reasons:
- There is a precedent already set. Several states moved faster than New Jersey and have already adopted a form of a flow-through entity tax, including Connecticut and Wisconsin. The good news is that, so far, the IRS has not challenged these states’ treatment and some experts believe the IRS would have already challenged the concept if they intended to (although in fairness it is still early).
- It is well established that under the U.S. Constitution, states have the right to tax their citizens and the businesses that operate in their state as they deem fit. Following that logic, New Jersey should have the right to design its tax system for flow-through entities in the manner of its choosing.
- The Internal Revenue Code amendments and the supporting conference reports of the Tax Cuts and Jobs Act appear to only preclude the deduction of state and local income taxes for individuals, not for entities.
- Paying state taxes is an ordinary and necessary business expense, and businesses have historically been able to deduct ordinary and necessary business expenses and state and local taxes.
How Will the Pass-Through Business Alternative Income Tax Act Work?
Here is an example of a situation that will assist in the explanation:
- Taxpayer’s W-2, interest and dividend income in 2019 was $400,000.
- Their income from a flow-through entity was $500,000 of taxable income in 2019.
- The New Jersey individual tax on their flow-through income in 2019 was $45,000…and not deductible against their federal taxable income.
Starting in 2020, because of the New Jersey flow-through entity level tax, the business entity can elect to pay tax on that $500,000 of income and take a corresponding deduction for those taxes paid against the federal taxable income that would flow to the taxpayer’s individual income tax return.
The result: While the taxpayer will report the income on their personal 1040, they will receive 100-percent credit for the taxes paid at the entity level and pay no additional state taxes than they would have paid prior to enactment of the Act. Because their federal taxable income is lower, they will save as much at $11,000 of federal tax as a result of their flow-through entity making this election. This will repeat itself year after year unless the federal government changes the rules again.
Compliance Guidelines Going Forward
The New Jersey Division of Taxation will be providing rules on how to report the income, how estimates are to be paid and other relevant implementation issues in the coming months.